The Myth of Russian Shock Therapy

In discussions about economic development, critics of the market economy often point to the case study of Russia which is widely known as one of the most corrupt and unequal economies in the world as evidence that “shock therapy” does not work. They claim that the radical approach of widescale privatization, deregulation, the release of price controls and the quick withdrawal of the state from the economy leads to unnecessary economic pain for ordinary people and places control of the economy in the hands of the few.

As an alternative, these critics often point to the incrementalism or gradual approach of Chinese Economic Reforms which successfully transitioned the country from a centrally planned economy to a mixed economy. They claim that China’s rapid economic expansion and rising living standards were the byproduct of a strong state which balanced both market forces and its control over essential resources to produce an outcome that was wildly different from the Russian economic program of shock therapy.

However, what critics of market economics fail to understand is that Russia in fact did not pursue a policy of shock therapy, but rather an incomplete program of economic reforms that were delayed, obstructed or distorted by political compromises.

The goal of this series will be to uncover the unique circumstances which ultimately shaped the period of economic reform in Russia from the 1980s to the 1998 Financial Crash, and so ushered in the country’s transition from state socialism to political capitalism.

Perestroika — The Great Awakening: 1985–1991

The impetus for Perestroika which roughly translates into “restructuring” was the economic stagnation that characterized the Brezhnev period (1964–1982), and the need for the Soviet Union to be able to compete with the United States in the Arms Race.

Two economists Vasili Selyunin and Grigori Khanin (1987) calculated that in the first half of the 1980s Soviet real growth was merely 0.6 percent a year.¹ By 1979, the Soviet Union was in a state of economic stagnation and the cost of maintaining its military rose “steadily by 3 percent a year, and the CIA gradually raised its estimate of the military share of Soviet GNP to 15–17 percent in 1987. But as the CIA overestimated Soviet GNP, a share close to 25 percent of GNP was more likely (Åslund 1990, Bergson 1997, Berkowitz et al. 1993). US defense expenditures, by contrast, stopped at 6 percent of GDP during President Ronald Reagan’s rapid arms buildup.”²

Recognizing the reality of the Soviet Union’s deteriorating economy which if left unresolved would cripple the country’s ability to resume its participation in the Arms Race against the United States, Mikhail Gorbachev pursued a policy of reform and modernization. This is made apparent by Gorbachev’s speeches in 1985 and 1987 as shown below:

The necessity of an acceleration of the social-economic development is also dictated by serious external circumstances. The country has been forced to devote considerable means to defense . . . facing the aggressive policy and threat of imperialism, it is necessary to strengthen the defense power of the Motherland persistently and not allow military superiority over us. (Gorbachev 1985, 5)…

The economic growth rates fell to a level that was actually approaching economic stagnation. We started evidently falling behind in one way after the other. The gap in efficiency of production, quality of products and scientific-technical progress began to widen in relation to the most developed countries, and not to our benefit. (Pravda, June 26, 1987)³

In Anders Aslund’s Russia’s Capitalist Revolution, Aslund writes that discovery of large oil and natural gas reserves in the 1970s alongside the boom in oil prices which lasted from 1973 to 1981 incentivized the Soviet leadership to neglect economic development in favor of devoting much of the windfall profits gained from its oil exports into the military.⁴

However, the profits from oil ran dry, and so in a desperate attempt to prop up the Soviet Union’s economy — Gorbachev jumpstarted a series of reforms in an attempt to turn the tide around which Aslund outlines below:

The new leaders all agreed on many technocratic improvements of the Soviet economic system, derived from Ryzhkov’s program. They included higher growth targets, change of investment policy, and improved wage policy and quality control. Waste and misallocation were so widespread that they reckoned improvement would be easy…

The late Brezhnev administration had concentrated on major “complex” programs, such as the Food Program (1982) and the Energy Program (1982), which set policies and directed investment to these industries. The early perestroika reinforced this focus on branch planning. Several new programs were adopted, a Consumer Goods and Services Program (1985), Chemicals Program (1985), and Machine-Building Program (1986), which led to huge, inefficient overinvestment. Soviet managers had strong incentives to start new investment projects to attract state funds, but not to complete them, because then their funds were cut. Many investment projects lasted for a decade or two. The number of investment projects ought to be cut, the managers’ incentives preserved the long-lasting construction projects (dolgostroii)…

The quality of Soviet output was miserable and declining. The Brezhnev regime had preferred carrots to sticks, and bureaucracy to markets, offering bonuses to producers who improved quality. But producers judged the quality themselves, naturally always sufficiently satisfied to receive their bonuses. Only military quality control was independent of producers. In late 1986, the Soviet authorities decided to create an independent inspection for state quality control (gospriemka), with highly qualified inspectors of great integrity and high pay. The new quality controllers did act severely, but their impact disrupted output volumes dramatically. This decline in production, and related bonuses, was more than the system could tolerate. Although gospriemka was the main economic theme in Soviet media from November 1986 until March 1987, this fierce campaign fizzled within a couple of months.

These slight improvements in the command economy bore no fruit, and were worsened by the Stalinist campaigns against alcohol and “unearned incomes.” Aslund details below how these campaigns had a terrible economic impact:

The economic impact, by contrast, was disastrous. In 1984, alcohol sales had accounted for 17 percent of total retail sales. The halving of these sales left a big hole in total supplies, which boosted all shortages. Almost 90 percent of alcohol sales went to turnover taxes, so tax revenues plummeted. Mainly because of the anti-alcohol campaign, the Soviet budget deficit in 1986 more than doubled to 6 percent of GDP, never to be reined in again. But the Soviet leaders did not even consider the fiscal effects.

The initial positive social results were not sustainable. The shortage of alcohol bred a large underground economy with ballooning organized crime thriving on moonlighting, poisonous liquor, and black market trade. Alcohol poisoning became a mass killer. The initial improvements were set to turn into equally great deteriorations. Perhaps more than any other single measure, the anti-alcohol campaign hastened the economic collapse of the Soviet Union.

Having learned nothing and forgotten nothing, like the Bourbons, the CPSU in the summer of 1986 launched another vicious neo-Stalinist campaign targeting private incomes. The official target was “unearned incomes,” which were never defined. The diffuseness of the target suited the control agencies, which could act at will, deciding whom to persecute. Fortunately, punishments were limited to confiscation and fines. In practice, this campaign was directed against small private earnings, primarily production sold through the collective farm markets.

Outrageously, this campaign concentrated on poor pensioners, who badly needed this income for their subsistence. It was replete with quotas for the planned number of culprits in each region. The media had already gained considerable freedom, and the public criticism of this campaign was devastating. An article titled “The Criminal Tomato” by Igor Gamayunov in Literaturnaya gazeta (August 12, 1987) reported how a local “commission for the struggle against negative phenomena” had ordered convicted hoodlums to carry out the lawless destruction of hundreds of greenhouses for tomatoes in the Volgograd region.

The direct effect of the campaign against “unearned incomes” was that private food supplies shrank and prices on the relatively free kolkhoz markets rose manifold. The campaign encouraged police to indulge in lawless racketeering against marginal private entrepreneurs. It contradicted early talk about the establishment of a rule of law, and it ran counter to Gorbachev’s whole policy, whereas Ligachev praised it in every speech from the summer of 1986, lamenting “speculators.” This campaign embodied Ligachev’s urge for police activism and socialist morality, underlining the limitation of Gorbachev’s power. It faded away in the second half of 1987.

Everything was wrong with these two neo-Stalinist campaigns. They were voluntaristic initiatives by two Politburo members who acted without prior analysis. Both campaigns were economically harmful, aggravating shortages. The anti-alcohol campaign seriously undermined the budget, whereas the campaign against unearned incomes reduced supply by scaring people away from private enterprise and fostering lawlessness by the authorities. To the Soviet public, these two campaigns were the dominant economic policies from 1985 to 1987, which badly undermined public confidence in Gorbachev, who was responsible for these government made disasters.

However, the real change came when the Law on Individual Labour Activity took effect in 1987 at Gorbachev’s behest. Providing a detailed account of this law’s effects and the subsequent decrees which came after, Jim Leitzel describes how in his book Russian Economic Reform the law greatly enhanced legal private economic opportunities in the form of cooperatives, but with some restrictions.

These restrictions were things such as individuals or cooperatives could not hire workers which reflected the Marxist prohibition on the commodification of labor.⁵ Also restrictive was how workers could not leave the state sector to join these new cooperatives, and so the law was aimed towards providing employment opportunities for people such as “housewives, pensioners, and students, and for moonlighters.”⁶

Restrictions on private activity were further eased in 1988, particularly by the Law on Cooperatives. Hired labour, generally illegal in the pre-perestroika Soviet Union, was permitted, and state enterprise employees could leave their jobs to work in cooperatives. State enterprises (or parts of state enterprises) could themselves become cooperatives, leasing the assets of the pre-existing enterprise. Joint ventures with foreign partners received government imprimatur, and cooperatives were given the right to sell their output at market-determined prices. In essence, cooperatives could operate like capitalist firms.

The single remaining legal concession to the ‘socialist’ nature of cooperatives was a continued prohibition on outside investors. The only people who were supposed to receive income from a cooperative were those who actually worked there. The cooperative sector mushroomed quickly following the liberalizing legislation. Starting from scratch in mid-1987, by June 1990 some five million Soviet citizens were working in cooperatives. All indications pointed to a tremendous increase in unregistered private economic activity as well.

These mild reforms ultimately led to what Leitzel called “spontaneous privatization” which he defined as the process which “gave many, if not most, Russian workers a chance to work for quasi-profit-maximizing, quasi-free-enterprise firms, even prior to the official privatization programme. In fact, as noted earlier in this chapter, much of the quasi-market economy was well-established long before the Gorbachev era.”⁷

Perhaps the simplest form of spontaneous privatization, common in the late 1980s and early 1990s, is known as the ‘privatization of profits’. Under this process, the informal activity that constituted much of the actual working of state owned enterprises moved completely to the forefront. Consider once again the example of a state-owned restaurant.

With the privatization of profits, the restaurant managers and employees began to charge whatever prices the market would bear.

The official menu and prices slipped further into meaninglessness. Diners negotiated over the constitution of the meal and the price. The restaurant accepted any inputs that it could acquire through official state channels, because those inputs remained low-priced. But since the suppliers of inputs also spontaneously privatized their enterprises, the restaurant probably had to pay quasi-market prices as well.

In short, the restaurant began to operate like any restaurant in capitalist countries, except that the remains of the old state sector had not entirely disintegrated.

The process of spontaneous privatization has been pervasive in Russia. The ‘liberal’ Russian economist Vitaliy Nayshul’ described the result in 1991, prior to official privatization: ‘State property de facto is nearly non-existent. Somebody has made a common law claim to every piece of public property, and it would be impossible to take them away without force.’

Perhaps more explicitly, this “spontaneous privatization” took on the form of what amounted to theft of state assets. By exploiting the legal loopholes and possibilities present in Gorbachev’s reforms, state enterprise managers and their workers took advantage of leasing capital goods owned by state firms for privately owned cooperatives. Leitzel describes below one way in which this may occur:

One quasi-legal route to privatization worked something like this. A state owned enterprise’s employees and managers formed several over lapping cooperatives. Various stages of the state enterprise’s production process were then controlled by the members of the cooperative that was established in the corresponding part of the plant. To acquire the legal right to use the state’s productive assets, the cooperatives leased the productive equipment from the enterprise.

This was far from an ‘arm’s-length’ transaction, however; the people who determined the cost of leasing the equipment were generally the same people doing the leasing. To the extent that higher-ups in the government apparatus who formally oversaw the state owned enterprise could control the leasing, they were brought into the cooperative as well. Eventually, there existed a crypto-private enterprise, otherwise little different from the state enterprise that preceded it. The incentives to efficiently produce goods consumers actually valued highly were much greater, however, once the enterprise moved into private hands, since the new ‘owners” well-being was tied closely to the enterprise’s profits.

The account of spontaneous privatization presented above is much oversimplified. There were many other devices for shifting state assets into private hands, beyond the official privatization plan. Some of these involved setting up a private bank and selling newly-created ownership shares of the enterprise to the bank.

The owners of the bank, who thereby became de facto stockholders of the enterprise, were typically the managers, employees, and possibly higher level officials of the enterprise. The details of how spontaneous privatization has been carried out remain obscure, and for good reason. Since the usual routes to spontaneous privatization were at best semi-legal, the participants had an incentive to muddy the waters as much as possible.

However, because of the fact that much of the “privatization” that was going on was legally dubious at best and that market transactions could potentially be illegal — this opened up an opportunity for corruption much greater than what existed prior to reform because “there is more private activity and even more state officials who might be able to stake a claim.”⁸

Since there is uncertainty about property especially so since the experience with economic reforms in the past had a tendency of suddenly changing or being upended, Leitzel argues that “[u]ncertainty regarding the future government policies toward Russian business is so great, however, that entrepreneurs have little confidence that they will even be allowed to operate in the future. Such uncertainty creates, quite rationally, an interest in short-term profits among Russian entrepreneurs.”⁹

If anything, there is a greater incentive for “‘vertical integration’, in which a downstream firm and its upstream supplier merge. If the construction firm cannot trust the timber company, it could buy the timber company — or vice versa. Then both stages of the transaction would be controlled by the same parties, greatly diminishing incentives to cheat. Russian enterprises, even prior to reform, tended to display a much greater degree of vertical integration than their Western counterparts, and not simply as a consequence of central orders. Without recourse to effective alternative forms of contractual protection, Soviet firms found vertical integration a useful means to govern transactions and ensure supplies.”¹⁰

These incentives made themselves apparent when one examines what the impact of the Law on State Enterprises had on state firms which passed a year later in 1988, and so helped culminate in a massive rent-seeking machine which Aslund astutely describes below:

Reformers tried to undertake all ideologically permissible reforms. They could make headway when their reform proposals found support among state enterprise managers, who had become a key constituency, but the managers accepted only what benefited their material interests. The unintended consequence was that the naïve Soviet reformers contributed to the building of an extraordinary machine of rent seeking.

On the one hand, each reform undermined communist dogmas and helped liberalize both the economy and society. On the other, the reforms contributed to the enrichment of a small elite of state enterprise managers and related operators. These partial reforms actually aggravated economic performance and caused an extraordinary macroeconomic crisis (Boycko 1991; Murphy et al. 1992, 1993). But this policy also drove a wedge between the newly rich and the old party ideologists, dividing the nomenklatura (Dobbs 1997). Large-scale rent seeking caused a horrendous economic crisis and facilitated the peaceful collapse of the Soviet Union.

By 1987, Gorbachev’s patience had run out. He organized a Central Committee plenum on economic reform in June 1987, which made the most important economic decisions of his reign. The Soviet leadership adopted the principal documents on the reform of the state economy, namely the Law on State Enterprises and Basic Provisions for Fundamental Perestroika of Economic Management. They were complemented with 10 decrees on major functions of the economic system and published as a book (O korennoi perestroiki 1987). This first attempt at a comprehensive reform came into force in January 1988. However, the outline of this reform compared poorly in quality, clarity, and consistency with the similar Hungarian socialist market reform of 1968, because many basic principles were muddled by compromise.

The outcome of the reform was very different from what Gorbachev had intended. From 1987 until 1991, he built a hothouse of rent seeking, undoubtedly without realizing that he was doing so (Yasin 2002, 118–21). The economic reforms contributed to this rent seeking by minimizing central oversight over state enterprises without demanding accountability, introducing free-wheeling cooperatives, accepting unregulated banks, and partially liberalizing foreign trade (Åslund 1996). The adverse results of all these partial reforms led to a continuous radicalization of the emerging economic thinking on markets.

One of Gorbachev’s first reforms was a partial liberalization of foreign trade. It started as early as August 1986, long before the domestic market was liberalized. Its primary goal was to break the foreign trade monopoly of the Ministry of Foreign Trade to the benefit of large state enterprises.

By 1988, more than 200 corporations had been granted the right to pursue foreign trade, and by 1990 their number approached 20,000 (Åslund 1991, 141). This liberalization was very popular among the managers of big state corporations, because they obtained an opportunity to make money through arbitrage on the enormous differences between low domestic prices and many-times-higher world prices.

In parallel, up to 3,000 so-called currency coefficients were introduced, as every significant foreign trade good was assigned its own exchange rate. The ratio between these currency coefficients varied from 1 to 20, offering extraordinary opportunities for arbitrage.

In late 1990, these coefficients were replaced by a unified commercial exchange rate, but even so the Soviet Union had one official rate, one commercial rate, and one plummeting black market exchange rate, permitting ever greater arbitrage gains.

The Law on State Enterprises passed in 1988 allowed for a great deal of freedom for state enterprises which were no longer held to the same degree of accountability as they were before reform. The law did “not abolish central planning, but it brought about a stalemate. The state could no longer govern enterprises, but nor could enterprises rely on any market. The Soviet economy was neither here nor there. It was about to fall into a deep chasm between two systems.”¹¹

Among the changes which were implemented was the introduction of super ministerial bodies or the merging of multiple ministries to streamline centralized control. The number of ministries “was reduced from 64 in 1979 to 55 in March 1988 to 37 in July 1989. The staff of the ministries was reduced by no less than 46 percent, from 1.6 million in 1986 to 871,000 in 1989 (Goskomstat SSSR 1990, 50).”¹²

However, the consequence of these changes led to the following outcome which Aslund describes below:

A traditional Soviet dilemma had been how to link enterprises to ministries. An array of intermediary associations had been tried, but Gorbachev wanted to do away with them to emasculate their “petty tutelage” of enterprises. As a result, each ministry would supervise about a thousand industrial enterprises, which was impossible. Gorbachev responded by calling for a merger of the 37,000 industrial enterprises into several thousand large production associations. The outcome was that the branch ministries, which had virtually owned the state enterprises, could no longer supervise them, so enterprises gained great autonomy.

Another important component of the Law on State Enterprises besides de-linking state enterprises from their respective ministries was the push by Gorbachev for “work self-management” which manifested itself in “elections” that saw incumbent managers remain in their positions which were really appointments by local party committees whose power was transferred to them by the ministries.¹³

By 1989, managers could no longer be removed and had effectively become quasi-owners of state enterprises. The dream of workers’ democracy, however, never became a reality in the Soviet Union. On paper, the Law on State Enterprises abolished central planning: “Annual plans are elaborated and confirmed by an enterprise independently on the basis of its five-year plan and concluded economic agreements.”

Yet, enterprises were admonished to consider control figures, state orders, long-term economic normatives, and quotas, which allowed the central planning authorities to command enterprises as before. This turned out to be one of many Pyrrhic victories of the conservatives, because glasnost allowed an extraordinary public reaction against Gosplan for its failure to implement the reform. By 1990, this central tutelage had collapsed. The enterprise managers were free to do what they wanted.

The next set of reforms concerned price liberalization which were passed in 1987, but these price reforms were “partial and contradictory. Prices for enterprises could be raised but not prices of consumer staples. Prices of the most important products remained centrally fixed, but more prices could be set independently. The idea was to reduce state subsidies and bring prices closer to world market prices. In reality the opposite happened because of aggravated macroeconomic imbalances, the plummeting exchange rate, and the prohibition against any significant adjustment of consumer prices. Enterprises could alter their production mix to products with higher margins, which led to aggravated economic performance, hidden inflation, and shortages. Why produce more if you could raise prices instead?”¹⁴

Taking into account all of the reforms mentioned in detail, Aslund explains how they all worked together to create this great rent-seeking machine and facilitated a widespread transfer of wealth from the state to individual state enterprise managers:

As state enterprise managers were becoming increasingly independent of the ministries, they wanted to channel the fortunes in their state corporations to themselves. Managers established private cooperatives on a mass scale and attached them to “their” state enterprises to transfer dead enterprise money into their own pockets. They sold attractive goods at low state prices to their private cooperatives, which accumulated the profit. Soon, they passed on the profit to offshore companies to keep it safe abroad. This management theft mechanism was fully established by mid-1988. From that moment, it was only a matter of time before the economic system would collapse (Yasin 2002, 118; Solnick 1998). Not only the state enterprise managers but also most of the later oligarchs started their businesses as cooperatives in 1988. Legalized theft from state enterprises through cooperatives and foreign trade was the name of the game.

Other forms of nonstate ownership emerged as well. The Law on State Enterprises allowed various forms of self-management, blurring the distinction between cooperatives, self-managed units of state enterprises, and leaseholds. At the end of 1987, joint stock companies with private ownership were also formed without any support from new legislation. Thousands of enterprise managers “leased” their state enterprises, which became a means of gradual spontaneous privatization…

Peculiarly, the Law on Cooperatives even allowed the formation of commercial banks as cooperatives. Soon cooperative banks mushroomed without any regulation. At the time of the collapse of the Soviet Union, Russia already had 1,360 registered commercial banks (Johnson 2000). Throughout the world, banks are the most regulated companies, but not so in the late Soviet Union. People were allowed to set up banks with minimal knowledge and tiny capital. These banks became means of activating dead enterprise money and many banks were attached to state enterprises. The old state banks joined the spoils by multiplying through splits. In 1990, inflation started to rise, but the government refused to increase state interest rates from the low single digits.

As a consequence, private commercial banks gained huge inflationary profits. They extracted vast state credits at minimal nominal interest rates, effectively usurping the mounting inflation tax.

Eventually, the Soviet Central Bank, Gosbank, tried to regulate the new commercial banks, but in 1990 it encountered competition from the newly formed Central Bank of Russia. These two central banks started competing for bank registration by driving down both taxation and reserve requirements for banks, leaving the banks the most deregulated companies in the Soviet Union.

They also competed in the issue of credit. Any serious budding future capitalist established his own commercial bank. With such a banking sector, hyperinflation could hardly be avoided.

A perfect rent-generating machine had been constructed. The liberalization of foreign trade allowed state enterprises to carry out arbitrage between low domestic prices of raw materials and high world market prices and between greatly varied exchange rates. The Law on State Enterprises permitted enterprises to keep the remaining profits, which had previously been confiscated by the state at the end of a year. The new cooperatives made it possible for enterprise managers to transfer the profits of their state enterprises to their private companies. The new commercial banks provided them with cheap state credits to finance their business.

One example illustrates how outrageous the distortions and rent seeking were. In 1990, a pack of Marlboro cigarettes cost $1 or 30 rubles in the street, which was also the black market exchange rate on the dollar. Incidentally, the official Soviet wholesale price of one ton of crude oil was exactly 30 rubles. However, the wholesale price was set in bank money, and one could purchase three bank rubles for one cash ruble at that time. Therefore, with the right contacts, a Soviet operator could purchase three tons of crude oil, worth $300 on the world market, for $1 or one pack of Marlboro. Little wonder that oil trading became the main source of early fortunes. Similarly, Yegor Gaidar (1999, 122) noted that at the end of 1991, someone with an official export quota for oil could pay as little as one ruble for one dollar, when the free exchange rate was 170 rubles per dollar.

Ironically, this rent-seeking machine had been formed by earnest reformers who wanted to establish a market economy, but they believed in gradual reforms. They sought support from state enterprise managers against dogmatic communists, but the businesspeople only accepted reforms from which they could benefit personally. These practices are often blamed on Yeltsin and his economic reformers, but Gorbachev and Ryzhkov established them between 1987 and 1990.

In fact, in many ways, one could argue that the criminality and corruption which existed implicitly before economic reforms were simply made explicit and in fact legalized. The passage below provided by Leitzel demonstrates this point:

Corruption and organized crime have a distinguished history in the pre-reform Soviet economy. While central planning mandated that the production and distribution of goods be largely the state’s prerogative, executing the plan required human intervention. Many individuals therefore had effective control over state resources, and they could (illegally) exchange these resources, often via barter, at prices that were essentially market-determined. The examples of trading on control of state resources are well-known and virtually endless. Butchers could sell choice cuts of meat ‘through the back door’, and nearly all retail clerks could engage in similar activity. Consumers could bribe officials to move to the front of queues for scarce commodities such as automobiles. Tolkachi, the supply expediters employed by state enterprises, used connections and bribes to secure supplies.

Even housing, which was constitutionally guaranteed in the USSR to be distributed on the basis of need and with very low rents, nevertheless was allocated in large measure via formal and informal markets.

As we have seen, the old system was one of near total corruption. The ‘ring leaders’ of this activity were party and state officials. They controlled access to the jobs (enterprise managers, for example) that led in turn to more direct access over goods. Just as important, party officials controlled the judicial system. Bribes thus tended to flow up through the party and state hierarchy. Indeed, the privileges and access to goods and bribes that accompanied important state and party posts were well established, and the term ‘mafia’ was used freely. Professor Gregory Grossman described the situation this way in 1977:

“At the very least one can deduce that the purchase and sale of positions for large sums of money signifies the profound institutionalization in the Soviet Union of a whole structure of bribery and graft, from the bottom to the top of the pyramid of power; that considerable stability of the structure of power is expected by all concerned; and that very probably there is a close organic connection between political-administrative authority, on the one hand, and a highly developed world of illegal economic activity, on the other.”

The systemic corruption in the former USSR thus can be characterized as an implicit form of organized crime, where the organization was provided through the Communist Party power structure. The bribes that flowed up the Communist Party hierarchy formed the tribute, the extortion money, or the informal taxes, that were a necessary part of doing business in the USSR.

Organized crime does not prosper in all environments. Mafias that are in the business of offering protection require a monopoly; otherwise, clients may be subject to competing claims for tribute, and less powerful mafias cannot actually provide protection. Organized crime likewise thrives under conditions where good substitutes for Mafia protection are not available. This is the role that illegality plays. An honest operator of a legitimate business in the US is less vulnerable to extortion because he or she can turn to the police. An operator of an illegal bookmaking service cannot do likewise. The hold that organized crime had on the distribution of liquor in the Prohibition-era US did not survive the legal competition that emerged following the repeal of Prohibition.

Pre-reform Russia presented almost ideal conditions for organized crime. The Communist Party had a legal (and even supra-legal) monopoly on power and the judiciary, and there were few competitors willing to challenge it. Furthermore, virtually all private business was illegal. Bribes could thus be demanded for any private economic activity, and even legal activity within the confines of the plan was not exempt. In many instances, in order to receive timely supplies of sufficiently high quality, state enterprises had to bribe representatives of their suppliers, which were other state enterprises.

Economic reform has, to a degree, undermined both the monopoly and illegality conditions that help to promote organized crime. The expected stability of the power structure, noted by Grossman, unravelled during perestroika. The monopoly on power held by the Communist Power has disappeared. ‘Private’ protection rackets can now compete, among themselves and with the remnants of the old system, to attempt to gain monopoly rights. This competition is more visible — explicit — than was the stable environment of the pre-reform system. The new competition in racketeering can more accurately be described as an increase in ‘disorganized’ crime, a breaking down of the old organizing structures, the Communist Party and the central economic plan…

The extent of Russian economic crime, whether organized or disorganized, is fostered by continuing controls over private enterprise, i.e., by partial reforms. It is virtually impossible for a Russian entrepreneur to operate entirely in accordance with the laws — in fact, the laws are themselves conflicting. While private economic activity remains to some degree illegal, organized crime has an opportunity to exploit business people, as they cannot generally turn to the police. And state officials continue to play a role in organized crime…

The former head of government anti-monopoly efforts in Russia, Valery Chernogorodsky, in comparing Russian with Western corruption, has said ‘Corruption encompasses more people at the top [in Russia], not just a few. It goes in all directions, from the bottom to the top of ministries — through bribes — and from the top to the bottom — through power.’ State controls have tremendous staying power, owing to the large profits that powerful state officials can glean from them.

Slow movement on the development of contract law also contributes to the prevalence of organize crime in Russia. If the state is unable to enforce private contracts, business people must look elsewhere. Substitutes for state enforcement include barter, collateral, or a reliance on personal connections and reputation. Another alternative, however, is the mafia, and under some conditions, this may be the best of the feasible options. Organized crime can provide the contractual security that business people need to enter into deals in the first place.

During a transition period in which the amount of private economic activity increases sharply — despite a measure of illegality — organized criminal activity can increase. More private economic activity means that there are more potential victims for criminals to extort.

In any case, Gorbachev’s gradual and partial reforms were largely seen as a failure. The failure of gradual reforms ultimately led to discussion about more radical solutions such as those proposed by Yegor Gidar, a Russian economist who advocated for a free market economy and would later on play an instrumental role in Russian Economic Reforms during Yeltsin’s Presidency.

In 1990 when Gorbachev became President, the first comprehensive plan for reshaping the economy was proposed called the Albakin Program which pushed for a market economy, and this program was further developed into the “500-day program.” But when presented with the 500-day program and the counter proposal brought up by the conservatives — Gorbachev refused to make a decision that ultimately led to the 1989 Economic Collapse as Aslund describes below:

These two alternative reform programs were presented to the USSR Supreme Soviet in September 1990, and the general expectation was that Gorbachev would adopt the Shatalin program [500-day program]. Instead Gorbachev organized a political circus, an art in which he was far superior to Yeltsin.

First, he criticized the government program because of its absence of a credible financial stabilization plan. Next, he favored a compromise between the two programs, although both sides stated that their approaches were irreconcilable. Then, he asked the highly respected liberal Academician Abel Aganbegyan to produce a synthesis.

Obediently, Aganbegyan did so, but his synthesis coincided largely with the Shatalin program. Now, Gorbachev turned critical, complaining that the Aganbegyan program contained “controversial clauses.”

In the end, the Supreme Soviet did not adopt any program. In all likelihood, Gorbachev engaged in the 500-day program only to kill it. He waited because it was too popular and Yeltsin had embraced it, but by October 1990 he might have felt that his obfuscation had done the trick and deflated its popularity.

By October 1990, Moscow’s political mood had changed, as hard-line communists went on the offensive. The reform discussion ceased. The popular sentiment was that the Soviet Union had seen too many reform programs (ten), but that nothing was done. The Soviet Union was sailing into a devastating economic crisis without a strategy. Actual economic policy became a mixture of desperate measures within the framework of the old Soviet system.

Gorbachev’s politicking in September 1990 was irresponsible in the extreme. This was his last opportunity to salvage his country from hyperinflation, and he intentionally missed the moment to adopt a comprehensive program of market reform for his political intrigues. By October 1990, a consensus had evolved among serious Russian economists that hyperinflation was inevitable and that the Soviet Union was bound to collapse. The thoughtful liberal insider Yevgeny Yasin (2002, 166) reckons that Gorbachev’s departure from power was set in motion by his rejection of the 500-day program. “At this moment, he gave in to the group of conservative party colleagues,” who would instigate the coup in August 1991…

Effectively, Gorbachev’s presidency was over and he could as well have resigned. The only questions left were how and when the collapse would occur…

By 1989, the signs of economic crisis amassed, and in 1990 the Soviet economy entered a terminal crisis. The chronic shortages became unbearable and prompted extensive rationing. The only good in surplus was money, and people hoarded whatever they could buy. Every Soviet home was filled with basic durable staples such as sugar, soap, and toilet paper…

In the early perestroika period, the traditional Soviet budget deficit of 2 to 3 percent of GDP had risen to 6 percent in 1986 (table 2.1). Expenditures on state investment, consumer subsidies, and social expenditures each increased by about 1 percent of GDP. At the same time, revenues declined because of smaller alcohol sales and lower world market prices for oil (resulting in lower foreign trade taxes). These fiscal problems were serious, although reparable, but the government just ignored them.

In the second stage of macroeconomic destabilization, 1988–89, the paramount problem was that annual wage increases more than doubled as a consequence of the Law on State Enterprises (figure 2.1). Managers concentrated on products with large profit margins, which boosted hidden inflation, and they happily passed on their inflationary gains to their workers as wage hikes. With lower tax rates, enterprise tax revenues declined by 3.7 percent of GDP from 1986 to 1989, and foreign trade taxes shrank with lower oil revenues by 1.8 percent of GDP from 1985 to 1989 (Goskomstat SSSR 1990, 612). Meanwhile, consumer subsidies grew by 3.4 percent of GDP from 1985 to 1989, because producer prices rose more than consumer prices, which were more strictly controlled. As a consequence, the budget deficit expanded to 9 percent of GDP in 1988 and 1989. The government was still able to act, drastically halving public investment expenditures from 1988 to 1990. Strangely, public expenditures remained roughly constant as a share of GDP from 1986 to 1990. The financial problems were grave but still manageable.

Toward the end of 1990, however, the Soviet macroeconomic crisis turned wild. One new driver was a populist social policy. The USSR Congress of People’s Deputies suddenly decided to raise social benefits by 25 percent, in competition with the Russian legislature, and in 1991 those benefits surged beyond control by 81 percent in Russia (Åslund 1991, 188; Goskomstat 1996, 116). The communists struggled to maintain power and hold the Soviet Union together by opting for populism, sacrificing any remnant of fiscal sanity. Like state enterprises, the USSR Congress was allowed much latitude but no responsibility. Wage increases continued to accelerate, and they skyrocketed by 97 percent in 1991 (Goskomstat 1996, 116). The summer of 1990 was the last time when the Soviet economic collapse could have been averted, and when Gorbachev dismissed the 500- day program in October 1990, he sealed the fate of his country.

In 1991, state finances broke down during the final stage of macroeconomic destabilization. The decisive blow came when the union republics that had declared themselves sovereign or independent in 1990 refused to deliver their revenues to the union treasury. They did not honor Soviet legislation, competing with the union in cutting taxes. The statistics for 1991 are sketchy because the Soviet accounts for 1991 were never completed and all crises were galloping. In any case, union revenues collapsed and the budget deficit skyrocketed to 31 percent of GDP, according to the European Bank for Reconstruction and Development (EBRD 1994). By the summer of 1991, the Soviet Union was no longer a financially viable state.

The Soviet government had ceased to pursue economic policy, limiting itself to certain acts of desperation. On January 14, 1991, Minister of Finance Valentin Pavlov replaced Ryzhkov as prime minister. His preoccupation was quick fixes to improve the market balance. He instantly shocked the public by declaring large ruble banknotes null and void, causing panic. At the same time, he partially liberalized producer prices, but not retail prices. In April 1991, the Soviet government at long last raised retail prices. The average consumer price level surged by no less than 70 percent, but that was by no means sufficient to clear the market (Koen and Phillips 1993). A free commercial sector evolved with prices several times higher and it absorbed some excess demand, but it remained marginal. Because prices were not liberalized, shortages continued to aggravate. Even so, by the end of the year the consumer price index had risen by 144 percent in Russia (EBRD 1994, 167).

In 1990, after the union republics had declared themselves independent, they established their own central banks. They started issuing credits in Soviet rubles, which meant that the Soviet Union had no less than 16 mutually independent central banks issuing ruble credits in competition with one another. This monetary competition was a guarantee in itself of the collapse of the Soviet Union. William Nordhaus (1990, 302–03) estimated that in 1989 the general price level had to rise by about 50 percent to eliminate the monetary overhang, and it skyrocketed for the next two years…

The foreign debt situation was considerably worse. From 1986, international loans were increasingly used to finance the Soviet budget deficit, although most of it was not financed by anything but money emission. The net foreign debt surged from $14.2 billion at the end of 1984 to $56.5 billion at the end of 1991 (figure 2.3). The outside world saw the mounting economic crisis, and the country’s creditworthiness declined. As a result, foreign debt service was increasingly short term and became alarming in 1990. Soviet foreign trade enterprises failed on a massive scale to pay on time toward the end of 1989, and by the fall of 1990 the accumulated international arrears amounted to $5 billion (IMF et al. 1991). Soviet foreign debts were not all that large in themselves, but the government’s refusal to deal with them until the country had run out of all foreign currency reserves was totally irresponsible…

Although the exchange rate was not liberalized officially, a partial liberalization occurred and the official exchange rate became increasingly irrelevant. The black market exchange rate was perceived by the public as the “real” exchange rate. For years, the standard black market exchange rate had been five rubles to the dollar, but in 1990 it moved from 20 to 30 rubles, that is, it rose six times from the end of 1988 to the end of 1990. In November 1989, the government allowed currency auctions for select state enterprises, and this overvalued official exchange rate moved from 10 rubles to the dollar at the end of 1989 to 25 rubles to the dollar by January 1991. By December 1991, the average Russian salary at the free exchange rate had plummeted to as little as $6 a month, which was a gross humiliation to the Soviet elite. As the ruble lost all value, the public hoarded cash dollars, and a far-reaching dollarization had taken place by 1991.

Officially, output grew slightly in the first five years of perestroika, but in 1990 not even official statistics could claim growth any longer, and in 1991 output approached free fall. The most plausible number is a decline in output of no less than 15 percent (figure 2.4). Because people had to spend ever more time queuing to use their money, it made little sense for them to work to earn more worthless money, and they reduced their real work time. The shortages also harmed production because factories suffered from scarcities of all kinds of inputs…

In the second half of 1991, the Soviet Union faced financial ruin. Soviet economic policy had evaporated, and no progress in economic policy occurred during the last one and a half years of Soviet government. An economic collapse was under way.

The Capitalist Revolution of 1991–1993

The economic reforms of Perestroika brought about the end of the Soviet Union — transitioning the economy from one that was stagnant to complete collapse.

One of the main causes of the Economic Collapse of 1989 was the irresponsible fiscal policy pursued from 1986 and onwards which was allowed to proliferate under Gorbachev’s tenure. Gorbachev personally defended himself by claiming that information regarding the Soviet Union’s budget and military expenditures were kept away from prying eyes.¹⁵ Restricted access to macroeconomic data, and an inability to use expertise when available ultimately led to this outcome.

Secondly, another cause of the economic collapse was “the gradual reforms separated control rights from cash rights and bred a machine of rent seeking. Incentives were distorted, and accountability disappeared altogether. Managers were preoccupied with tunneling state wealth out of public enterprises to private offshore havens. By 1990 this rent seeking made economic collapse inevitable.”¹⁶

Thirdly, “the partial national and democratic empowerment of the Soviet peoples [in regards to Soviet satellite states such as Poland and Glasnost more broadly] bred populism, because nations and their peoples were allowed to demand more economic benefits, but they were not permitted actual power. The Soviet finances collapsed in 1991 because the republics stopped delivering revenues to the union treasury, and much of the inflation was caused by the competitive issue of ruble credits by 16 central banks. This rendered the financial and monetary disasters terminal in late 1990.”¹⁷

In 1991, the August Coup that took place in that same year led to the rise of Boris Yeltsin as President and saw the demise of Gorbachev as a relevant political figure who continued to push for the minority view that socialism could be reformed. The first thing Yeltsin did as President was to dissolve the Soviet Union, and to reform the institutions of the Russian Government to better centralize control of the executive branch. Shortly after, Yeltsin announced his program of radical economic reform which received overwhelming support from the Parliament.

Given the direness of the economic situation, Russia was “set to repeat the radical economic reforms of Poland in 1990 and Czechoslovakia in 1991, with a concentration of major reform measures in a ‘big bang’ in January 1992.”¹⁸ But as the “macroeconomic crisis deepened in late 1991, the reformers turned more radical and opted for a more concentrated big bang. Both Yeltsin and Gaidar used the term ‘shock therapy,’ although their actual approach to reform was somewhat partial. The reforms came to lack the desired concentration and comprehension, but that was difficult to avoid in the post Soviet chaos.”¹⁹

One of the key mistakes that Yeltsin would make that would severely affect his government’s ability to carry out reforms later down the road was his “strange and exaggerated affection for state enterprise managers… Yeltsin’s private life complicated his policies and particularly his personnel decisions. Like most old party apparatchiks, he was a heavy drinker. When he drank, he wanted privacy and liked the company of big, heavy, middle-aged men such as himself. These men tended to be enterprise managers, KGB officers, and old apparatchiks… These men were reactionaries and several were serious criminals who fought the reformers during the day and drank with Yeltsin at night. The banya team intentionally made Yeltsin as drunk as possible, to promote their policy line. The reformers had no access to this company, and their drinking habits were no match either. For long periods, Yeltsin disappeared from the public eye, and the suspicion was that he devoted himself to heavy drinking in this bad company.”²⁰

The Problem of Inflation & Shortages and the Pro-Inflation Lobby

The issues most pressing for the Russian economy in 1991 “were massive shortages and high inflation, leading to demonetization and dollarization.”²¹

But some gained from the high inflation, Aslund explains below:

A small rent-seeking elite of state enterprise managers and their companions benefited from subsidies and subsidized credits paid by the state, but society paid the inflation tax that financed their fortunes. The destabilizing subsidies were often extracted through bribery, and since such contracts were not legal and thus could not be secured in court, the many commercial banks that thrived on the high inflation became a gangster killing field. Bringing down inflation was vital for the well-being of society, but it was resisted by a commercial elite that was as powerful as it was criminal.

This was further worsened by the fact that there were 15 other central banks (propped by regional/provincial governments) that existed alongside the Central Bank of Russia which “issued ruble credits without control or coordination… Money was not unified, because different shops existed for people with special coupons, and rationing was extensive. Nor was the exchange rate unified. According to the most credible estimates, the Soviet budget deficit in 1991 was about 31 percent of GDP (EBRD 1994). Public expenditures skyrocketed beyond control. Since prices remained regulated, price subsidies surged with rising costs. Russia also suffered from a huge monetary overhang, because people were compelled to hold much more money than they desired.”²²

However, one might wonder how could firms in the financial sector benefit from an inflationary environment? Andrei Shleifer in Without a Map: Political Tactics and Economic Reform in Russia explains how entrenched economic interests used the country’s loose monetary policy to engage in unjust profiteering:

In the early 1990s, two important constituencies had both a reason to favor continued inflationary finance and sufficient leverage over government policy and the day-to-day operation of the financial system to assert their preferences.’ These were: (1) the central bank, along with many of the new or privatized commercial banks; and (2) subsidized enterprises, farms, and budget-sector organizations (the military, schools, hospitals, etc.).

[T]he central bank of Russia was no enemy of inflation. The bank and its employees benefited directly from the massive flood of centralized credits it issued to support specific enterprises and sectors. In 1992, such directed credits amounted to an estimated 18.9 percent of GDP.

Interest payments on these credits went into the central bank’s profits. Its profits that year came to a reported 448 billion rubles, or almost $2 billion at the average exchange rate for the year-about 2.4 percent of annual GDP! Of this, about two-thirds went into a social fund to stimulate the performance of the bank’s employees (one assumes that they were well stimulated).

Such profits and their distribution were entirely legal. In addition, rumors continually circulated that employees of the central bank had demanded bribes in return for allocating centralized credits to particular enterprises or banks. (One bank director openly admitted having paid a large sum to intermediaries to secure a central bank credit.)

Coopers and Lybrand, which audited the bank’s accounts for the year, reported that it had found “distortions, mistakes … and possible abuses,” and complained of “a very high level of unexplained sums.”

Commercial banks benefitted from inflation and the policies that caused it in two ways. First, selected banks got the lucrative assignment of transferring the centralized credits that the central bank was allocating to specific enterprises and sectors. Officially, the banks earned a margin of 3 percent on these transactions. In fact, many were able to extract far more, soliciting bribes from designated recipients, delaying the credits for months while inflation eroded their value, or directing them to enterprises conveniently co-owned by the banks or by the managers of those banks.

A second way that the commercial banks profited from inflation was by paying negative real interest rates to their depositors. In most of the months of 1992, the commercial banks lent out on their own account (i.e., not merely channeling centralized credits) far less than they took in as deposits from households and enterprises. They could then use these deposits to buy commodities or foreign currency and profit from the rise in their value as inflation drove ruble prices up and the exchange rate down, all while watching the nominal value of their debt and interest payments to depositors fall. Two economists who tried to estimate the distributional gains and losses from inflation reckoned that the financial sector received about 8 percent of Russian GDP in 1992 from such operations. It did so by exploiting the large positive spread between the rates it paid to depositors and the rates it could earn by relending or investing the deposits.

Schleifer explains that commercial banks were able to extract such a large rent because of negative real interest rates on bank deposits which he explains below has several causes:

In part, the banks benefitted from the temporary lack of competition. Amid the chaotic conditions of early transition, enterprises faced a restricted choice of local banks that could service their accounts. Enterprises were probably willing to accept lower interest rates in return for the added security of dealing with a familiar partner. At the same time, depositing money in a bank at negative real interest rates was probably one of the ways in which enterprises paid kickbacks to banks in return for locating centralized credits. Such deposits may have also served as a means of “nomenklatura privatization.” The director of a state enterprise would deposit his enterprise’s funds in a commercial bank which he or an associate secretly owned. Any profits the bank might make at the enterprise’s expense would accrue to the director and his or her private partners.

In large part, negative real interest rates on deposits derived from government policy. At the banks’ repeated requests, the government enacted protectionist measures to limit competition from foreign banks for Russian business. During most of 1993, commercial banks were lobbying both parliament and the government to protect them from foreign banks, and entry of international banks was heavily restricted. In November 1993, Yeltsin signed a decree actually prohibiting foreign banks from opening accounts for Russian clients. Some Russian bankers were lobbying not only for restrictions on foreign banks but even for protection from domestic competition. One, for instance, demanded that the system for registering new commercial banks should be made stricter.

In addition, rates in the market for household deposits were strongly influenced by those of Sberbank, the gigantic state savings bank. With more than 34,000 branches, Sberbank held about two-thirds of all household deposits in the mid-1990s. The government actively discouraged Sberbank from raising its rates, a move which other commercial banks would have had to follow.

Third, tax policy created an incentive for banks to keep their deposit rates low. For the purpose of calculating taxable income, banks were only allowed to write off the interest payments they made up to the central bank discount rate plus 3 percent. If they offered higher deposit rates, not only would their profit margins shrink but they would also have to pay taxes on a sum larger than their actual profits. The central bank discount rate far below the inflation rate for most of 1992 and 1993 became a focal point for the major banks.

The extent of this rent-seeking was so great that the four main sources of rent which were regulated commodity exports, subsidized grain imports, subsidized credits, and state subsidies “amounted to an incredible 90 percent of Russia’s GDP in 1992. And that does not include some rents such as tax exemptions. Presumably, rents have never been larger as a ratio of GDP anywhere in the world than they were in the former Soviet Union in 1992. Select citizens became conspicuously wealthy when they transferred these rents and subsidies from state enterprises to their private accounts through transfer pricing or outright theft.”²³

Aslund briefly elaborates below on how the regulated commodity exports and subsidies on imports worked in the favor of states enterprises:

First, total export rents were no less than $24 billion or 30 percent of GDP in 1992. State-controlled, domestic prices of commodities were at most one-tenth of world market prices, and more than 70 percent of Russia’s exports were commodities subject to export quotas (Aven 1994, 84). Total Russian exports outside the CIS amounted to $42.2 billion. Collected export tariffs were some $2.4 billion, while GDP was only $79 billion in 1992, because of the very low exchange rate (World Bank 1996b).

Another large source of rents was subsidized imports, which the IMF (1993, 133) calculated at 17.5 percent of GDP in 1992. Because of the fear of starvation, Russia maintained special exchange rates for so-called critical imports until 1993, subsidizing such imports to 99 percent. The Russian importers of grain bought hard currency for only 1 percent of the going exchange rate in 1992, allowing them to pay only 1 percent of the world market price for imported grain, while bread was sold at ordinary domestic prices. Ironically, $12.5 billion of foreign credits designated as humanitarian aid did not support but rather undermined economic reform efforts, whereas the outside world did not provide any support for the economic reforms in the first half of 1992.

The banking sector was able to maintain this inflationary policy by lobbying members of the Russian Parliament which was in charge of appointing and removing the Chairman of the Central Bank at will. One Chairman in particular was Viktor Gerashchenko whose appointment was strongly supported by the banking sector, and he served to carry out threats against the government by the banking sector should any attempt at monetary tightening be pursued as Schleifer describes below:

If all else failed, and the government continued to insist on monetary tightening, the bank could threaten perversely to satisfy the government’s request in a way that would undermine all public support for the policy. Further cuts to the money supply, bankers warned, would completely disrupt financial flows through the economy. The bank was well positioned to make its warning come true.

In 1992, there was no alternative nationwide payment system that could have bypassed the bank’s network of regional clearing centers. Money transfers-whether payments between enterprises, tax payments, or the government’s own transfers to citizens-all passed through the central bank’s system. In this sense, the central bank’s implicit threat to slow payments to a crawl was highly credible. While exacerbating public annoyance with the government’s strict monetary policy and attracting others to the campaign for expanded credit, such a strategy would also make the bank money on the side. Delays in money transfers were already increasing in 1992. If transfers were to slow still further, the price of bribes to bank employees to expedite transactions would naturally rise.

Publicly, commercial banks attacked the central bank for inefficiency in making payments. Sergei Yegorov, president of the Association of Russian banks, complained in May 1992: “As everyone knows, if a transfer is for more than 5 million rubles, they always ‘lose’ it in the central bank. They also accused the central bank of dragging its feet in approving plans for a private clearing system. In reality, however, the commercial banks themselves probably temporarily “lost” trans fers even more frequently than the central bank did. The profits that could be made by speculating with money en route between clients under conditions of extreme inflation were hard to resist. The rapid and universal growth of interenterprise arrears in 1992-caused partly by commercial banks deliberately delaying funds-helped to unite the industrial giants, whether profitable or unprofitable, into one political camp, furious at the government’s monetary tightening, which they blamed for the payment delays.

Besides threatening the government, the banking sector could influence government officials by financing their electoral campaigns such as Yegor Gaidar — a prominent reform economist who “met with representatives of leading commercial banks.”²⁴

In the words of the newspaper Kommersant: “Cochairman Yegor Gaidar declined to offer any introductory words, and directly asked the bankers how they envisioned the future structure of the banking system and how the government could currently help the bankers.” He evidently already knew the answer. Some days before, both ultraliberals Gaidar and Boris Fyodorov had publicly attacked the central bank for issuing licenses to five foreign banks. The foreign competition, Gaidar said, threatened to lead to a “precipitous slump in the domestic banking sector.” Russia’s Choice-along with many other blocs running received contributions from leading commercial banks. Commercial banks were also attractive places of employment for ministers after they left office. The minister of foreign economic relations in 1992, Pyotr Aven, for instance, resurfaced soon after leaving government as a director of Alfabank.

After the banking sector, as once mentioned before — you had enterprises largely based in agriculture, fuel and energy, and defense which received subsidies and cheap credit. Even though inflation eroded the savings of these enterprises, the subsidies and cheap credit provided by the state offset those costs.

The World Bank estimates that 18.9 percent of GDP was handed out as central bank credits at highly negative real interest rates in 1992. Of these, 6.8 percent went to agriculture, 4.4 percent to industrial enterprises to finance working capital and clear arrears, 1.9 percent to the fuel and energy sector, and 0.4 percent to finance conversion of defense-sector enterprises.

In addition, the government issued some of its own credits at subsidized rates to ease the plight of insolvent enterprises and to finance investment and conversion in the defense industry…

The leverage of subsidized enterprises, farms, and budget-funded organizations derived from their representation in parliament and their ability to mobilize mass protests that could weaken the government politically. From early in 1992, Arkady Volsky’s alliance of managers from heavy industry and unions had been organizing the opposition to tight monetary policy…

As is common in the politics of inflation, the coalition of stakeholders in favor of loose money represented a relatively cohesive group that was highly conscious of what it stood to gain. The main victims of inflation-the population en masse-were disorganized and largely unaware of the relationship between soft credits and price rises. No pressure group in favor of stable money existed to balance the demands of the proinflation lobby.

While newly formed groups did start to apply political pressure on behalf of pensioners who had lost savings to high inflation, their goals were not to cut inflationary credit emission but rather to secure massive additional monetary grants to compensate them.

In short, the central bank, favored commercial banks, and subsidized enterprises and farms profited from inflation to the tune of a considerable share of annual GDP during the early 1990s.²⁵

However given all these obstacles propped up by the pro-inflation lobby, it would be dishonest to say that there wasn’t a chance for the reform government to change the tide in regards to inflation — Aslund makes this point clear when he states that in the same year that price liberalisation was done, macroeconomic stability could been pursued had compromises not been made:

One of Gaidar’s advisors, Sergei Vasiliev (1999, 86), reflected:

“In the period following the Soviet Union’s collapse, all the major social groups were, in effect, paralysed. Actions taken by the government, consequently, were of tremendous significance. . . . The reform government failed to make good use of that short period when it had virtual freedom to do what it deemed necessary. The reformers claimed that there was no significant resistance to reform, but in practice they constantly made compromises with the conservatives. . . . Still, thanks to the institutional vacuum, many transformations were quite smooth. The first phase of the reform was more successful than the reformers had expected, but that period did not last long.

As early as spring 1992, the government came under strong pressure from various lobbies. The agrarian lobby was the most effective, and by summer of 1992 it had actually wiped out the success of stabilization in the early months of reform.”

The first severe confrontation between the reform government and the Russian Congress of People’s Deputies took place in April 1992. Khasbulatov had mobilized a majority of the parliament in opposition to Yeltsin. His two key demands were a looser, even more inflationary, fiscal policy, and reduced power of the president…

Yeltsin was a patently poor negotiator. When negotiating with the Congress, he started with concessions, making certain personnel changes before its session and promising to replace three to five ministers with experienced industrialists, but he did not secure anything in return.

Rather than taking the lead, Yeltsin took a lot of time off in early 1992. He marveled over how wonderful Russia’s state enterprise managers were. They were well organized in the Russian Union of Industrialists and Entrepreneurs, which had been founded by the old liberal CPSU apparatchik Arkady Volsky, who was a skillful man for all seasons. Volsky opposed radical market reforms, because his constituency benefited from subsidized credits and foreign trade arbitrage. Now, Yeltsin had forgotten why he had launched radical economic reform and wanted “industrialists” in his government, not understanding that they were the main opponents of his reforms (Yeltsin 1994, 164–73).

After having failed to liberalize energy prices at the beginning of 1992, Gaidar tried to do so repeatedly, but now Yeltsin was dead set against it. At a cabinet meeting in May 1992, Yeltsin sacked Gaidar’s minister of energy, Vladimir Lopukhin, for having advocated energy price liberalization, which Gaidar did as well. Yeltsin did so without having informed Gaidar (Yeltsin 1994, 166–67).

In May–June 1992, Yeltsin appointed three heavy industrialists as deputy prime ministers. Most prominent among them was Viktor Chernomyrdin, the last Soviet minister of gas industry and the founder of Gazprom, the state corporation that compounded all the Russian assets of his former ministry. In June 1992, the parliament sacked Matiukhin as chairman of the Central Bank, accusing him of excessively strict monetary policy. In came the last chairman of the Soviet State Bank, Viktor Gerashchenko, although he had been complicit in the August 1991 coup and had carried out the unpopular Pavlov monetary confiscation in January 1991. Yeltsin elevated Gaidar to acting prime minister in June 1992, but these personnel changes meant that the first attempt at radical economic reform was over. For the rest of 1992, Russia slid toward hyperinflation with a minimum of policy…

The banking sector lost these benefits when Russia finally stabilized in 1995. However, the question remains — why would the beneficiaries of inflation support macroeconomic stabilization when they had opposed it all throughout the period of economic reform (1991–1994)?

Schleifer argues they were co-opted into accepting a reduction in “the commercial banks’ inflationary rents by raising the discount rate and stopping subsidies channeled through commercial banks, they were simultaneously creating new temporarily noninflationary opportunities for many of the major banks to earn significant profits. This compensated the banks for the disappearance of opportunities tied to inflation and changed the nature of their objectives in lobbying the government. The central bank was itself brought on board this policy in a similar manner: it was given a new means of earning large commissions and profits that could replace in part the foregone profits from inflationary credit extension. It also won continued legal recognition, in the 1995 Law on Central Banking, of its right to decide autonomously how to dispose of much of its profits.”²⁶

In May 1993, the Ministry of Finance launched the first short-term state securities (GKOs)-treasury bills with a maturity of from six weeks to twelve months. Over the next three years, the nominal value of the main government securities in circulation grew from nothing to about 159 trillion rubles ($31 billion). These securities were sold in primary auctions by the central bank to a small number of authorized primary dealers who could then resell them on secondary markets in Moscow, St. Petersburg, Rostov, Vladivostok, and other cities. Treasury bill markets are known to be an important financial tool in macroeconomic stabilization, as they provide a source of funds to cover the budget deficit that does not require printing more money. Less widely recognized are the ways in which such bond markets can serve a political goal crucial to the sustainability of a stabilization program.

In this new market in Russia, investors could get large positive returns by lending the state short-term money. For most of 1994 to 1996, rates of return on GKOs were far above the inflation rate, rising at one point to more than 150 percent a year in real terms. And profits from dealing in GKOs were initially tax free. Such high rates-particularly in months shortly before the presidential election-might be viewed as risk premia compensating for uncertainty about the government’s commitment to the market and about future inflation rates. But since the risk could be fully or partly eliminated by advance information of changes in government policy, this in effect served as a barrier to protect rents in the market for those dealers sufficiently close to the financial authorities to expect to be informed.

Not surprisingly, the main investors and intermediaries in GKOs were none other than the major commercial banks. Primary issues were limited to a group of authorized dealers, initially numbering twenty-five, of which nineteen were commercial banks and six were brokerages. By far the largest holder of government securities, with more than 40 percent of the total in mid-1996, was Sberbank. It was followed by another bank that still had a majority state ownership, Vneshtorgbank, and by a string of the largest independent commercial banks (see table 4.1). Small dealers were believed to hold at most 10 to 30 percent of the market.

The Ministry of Finance complained about the cost to the budget of paying such high yields. But by restricting access to the primary GKO auctions to preselected dealers and sheltering the market from direct participation by foreign investors, the state itself prevented the rates from being driven down by broader competition. One business newspaper saw evidence of covert coordination by the major auction bidders to keep prices low and yields high (the average price at one auction was almost identical to the minimum price).

At the same time, another reporter complained, “ordinary Russians are effectively shut out of the market, as are other small investors.” In general, the period of the shift from inflation rents to GKO profits coincided with a rapid concentration of the banking sector, which left 55 percent of total banking assets on the accounts of the 30 largest banks, many of them among the biggest GKO traders. Nonresident investors, while permitted to buy up to 10 percent of each issue at the primary auction via certain Russian banks, were prohibited from selling them on the secondary market. And they were not permitted to repatriate the profits for a year. The rate of profit they could earn was also held far below the rate for residents. In March 1996, for instance, while the nominal interest rate on GKOs for residents was about 70 percent, for nonresidents it was only 20 to 25 percent.

To some extent, the high profits major banks were able to earn in this protected market made up for the rents they were losing as inflation fell. Between the end of 1994 and May of 1996, the level of commercial banks’ investments in state securities grew by eight times, and in the first half of 1996 the ratio of profits to assets of the hundred largest banks rose from 3.37 to 4.03 percent. At the same time, federal budget expenditures on servicing the domestic debt soared from 1.2 percent of GDP in 1994 to 5.4 percent in 1996… The banks that made this transition had been transformed from a proinflation to an anti inflation lobby…

This change did not suit all banks. It favored those large and well connected enough to play the GKO market with relatively low risk and damaged those most dependent on centralized credits. In some cases, new banks emerged as the major GKO dealers, and some former cheap money channeling banks sank into obscurity. In other cases, banks smoothly made the transition from earning high returns on their borrowing to earning high returns on their lending. In any case, a sufficient support base of favored and wealthy banks was kept intact.

This was further reinforced by the controversial “loans for shares” privatization auctions which will be discussed later in this article which guaranteed the support of major banks. Shleifer explains how mass privatization in 1992 and onwards were used to help co-opt vital interest groups into supporting macroeconomic stabilization which included commercial banks, certain enterprises, and the Central Bank:

In carefully controlled tenders, certain favored banks were permitted to “win” contracts to provide credits to the government budget on the security of large blocks of shares in valuable raw materials and other companies. The piquancy of these deals lay in the fact that the winning bloc of credits, while a fraction of the current value of the shares at stake, was considerably more than the cash-starved government could be expected to raise by the time the credits came due. Thus, the winning bidders stood to realize large gains when the government defaulted.

The loans-for-shares auctions helped to attract banks that had grown fat on inflationary rents and GKO trading to invest some of their gains into the more promising corners of Russian industry. One result was to accelerate the growth of major financial-industrial groups, somewhat similar to the Korean chaebols. These groups, each run by its own “oligarch,” usually started as a bank or energy company, but then expanded through acquisitions. By 1996, many also had large stakes in major media outlets, which they often used to further business or political intrigues and to promote an image of themselves as central to Russian politics. After Yeltsin’s reelection in 1996-in a campaign that various business empires supported-two of the leading oligarchs, Vladimir Potanin and Boris Berezovsky, were given positions in the government.

The loans-for-shares auctions gave the winners a strong interest in low inflation. High price rises would have reduced the real value of the credits the government owed them and made it easier for the government to repay the loans-in rubles devalued by inflation rather than give up the shares. Most of the enterprises put up as collateral for the auctions desperately needed foreign investment to exploit their natural-resource reserves more efficiently, and the banks generally hoped to resell the enterprises to international investors. Nothing would scare away foreign direct investment quicker than continuing high inflation. In a broader sense, as private ownership expanded through mass privatization, there emerged a constituency of shareowners with an interest in financial stability and a return to growth.

The central bank might have been expected to oppose the elimination of subsidized centralized credits from which it earned lavish profits. To the surprise of many observers, however, from 1995 on the bank actually helped to reduce inflation…

Even more important, the central bank itself became one of the main dealers in government securities. And the profits it earned from such operations went in part to the social fund to finance benefits for the bank’s employees. In 1997, revenues from operations with government securities totaled 5.7 trillion rubles (almost $1 billion) according to the bank’s balance sheet. The bank’s profits for the year came to 2.8 trillion rubles ($482 million), of which half went to the federal budget and the other half ($241 million) to the bank’s reserve and social funds…

Allowing the central bank the extremely lucrative business of buying GKOs that earned rates of return far above inflation, and allowing the bank itself to dispose of half of its profits, helped to coopt its leadership. The bank was even able to avoid splitting some of the profits with the federal budget by using its pension fund to buy the GKOs. And, just as for the commercial banks dealing in GKOs, any rise in inflation would have cut into the real value of the treasury bills’ fixed payoff. The central bank, too, acquired a new stake in stable prices.

The second phase of economic reforms which were launched between 1991 and 1992 was mass privatization carried out using vouchers and the “loans for shares” program. Shleifer describes the privatization program(s) below:

From October 1992, vouchers, each with a nominal value of 10,000 rubles, could be acquired at a local branch of Sberbank for 25 rubles (about $.07). By the end of January 1993, 144 million Russians, 97 percent of the population had claimed their vouchers. Citizens could sell their vouchers on a fast-growing private market, invest them in privatization investment funds, or use them to bid for shares in specific companies.

In early 1992, a presidential decree required eligible enterprises to turn themselves into joint stock companies-to “corporatize”-by November 1, 1992. Corporatization made it possible to sell or distribute the shares in these firms. Although corporatization did not meet the president’s deadlines, about 80 percent of the 20,000 eligible medium and large enterprises had been turned into joint stock companies by April 1994, laying the groundwork for the next stage of privatization: voucher auctions. In these auctions, the government exchanged shares in corporatized firms for vouchers. A May 1993 presidential decree established that enterprises had to sell at least 29 percent of their shares at voucher auctions within three months of corporatization. The first eighteen voucher auctions were held in December 1992 and the monthly total grew in the first months of 1993, stabilizing by midyear. Almost 14,000 Russian enterprises had held voucher auctions by mid 1994…

The privatization program envisioned one final stage: cash sales of shares designed to attract large-scale investors to privatized companies. This stage got off to a slow start in late 1994. In the first nine months of 1995, the government planned to sell the remaining state share in 7,000 enterprises to investors and hoped to raise about $2 billion. In fact, by November 1, shares in only about half of these companies had been sold, raising a total revenue of about $500 million. Enterprise managers and regional governments resisted such sales, which diluted the control of insiders. One survey of midsize and large enterprises found that employee ownership actually increased during this period.

Faced with the failure of cash auctions to raise sufficient revenues and a growing budget deficit, the government radically changed its privatization strategy in late 1995. In a controversial series of deals, it tried to speed things up by involving major commercial banks in the privatization process on highly attractive terms. State shares in twelve profitable energy sector and other enterprises were used as collateral against major bank loans to the government. If the government decided not to repay the credits which totaled about $1 billion — the banks would have the right to sell the shares previously given to them in trust and keep 30 percent of the capital gains. The circumstances of the auctions in which the same banks sometimes served both as organizer and bidder, and larger bids were occasionally disqualified on technicalities aroused fierce criticism in parliament and in the press.

After the deadline passed in September 1996, banks began selling off the state shares packages. Between November 1996, and February 1997, three such sales occurred for shares in Yukos, Sidanko, and Surgutneftegaz. In each of these three cases, the trustholders themselves or an affiliated company bought the stock. The perception of corruption in these deals disproportionately shaped the public view of Russian privatization, which if anything suffered more from entrenched insiders than from corrupt outsiders.

In summary, the reform government’s efforts in 1991 to 1993 can summed up by Aslund’s assessment below:

In the fall of 1991, Yeltsin wanted to undertake radical market economic reform, and he did not shy away from talking about shock therapy. His basic strategy was sensible and delivered at least six major successes through reforms that proved viable and irreversible. First, price deregulation, the basic precondition for a market economy, was extensive. Second, imports were almost completely liberalized, rendering Russia an open market economy. Third, Russia unified its exchange rate. Fourth, by attempting to cut military procurement by 85 percent, Gaidar single-handedly beat once and for all what had long been considered an unbeatable military-industrial complex. Fifth, mass privatization established predominant private ownership, which provided the basis for subsequent economic recovery. Finally, in 1992 and 1993, the number of small private enterprises mushroomed as never before or after, with a critical mass of nearly a million private enterprises legally registered. Near hyperinflation was less harmful to small private firms than the resurgent bureaucracy that subsequently strangled their expansion. In sum, most, although not all, preconditions for a market economy had been created.

In each case, reforms worked because they were simple and radical. The unwieldy, extensive, and corrupt Russian state could not carry out any piecemeal reforms.

Within the economic reform, all problems arose from the failure to be sufficiently firm and radical (Da˛browski 1993b). The main shortcoming was the inability to control inflation, which was primarily caused by the permissive monetary policy of the Central Bank and the persistence of the ruble zone. The Gaidar government opposed both but it was defeated. Without any restraint on monetary policy, inflation prevailed. The strong energy lobby convinced Yeltsin that he must not liberalize energy prices, which kept their rents huge in 1992 and 1993. An early liberalization of energy prices would have solved this problem, but that might not have been politically possible given the extraordinary price discrepancy. The big state enterprise managers spearheaded all these destabilizing acts, while also extracting subsidies from the state.

Fortunately, none of these rent-seeking activities was tenable in the long run. People learned about the harm of high inflation from their own suffering. Many rents dissipated over time, but fundamentally macroeconomic stabilization was a political question: Would a small elite be allowed to thrive on inflationary gains or not?

The politics of transition turned out to be the opposite from what had been expected. The reformers feared, and their opponents hoped for, strikes from the coal miners and other workers who had been so militant from 1989 to 1991, but strikes ceased with reform, even though real wages fell precipitously and wage arrears proliferated. Another widespread worry was that the public would take to the streets when prices were liberalized, but, again, nothing happened. When prices of key consumer staples are hiked, people often protest, but not when prices are liberalized on a broad scale…

The political problem was not the losers, but the winners. The title of a seminal article by Joel Hellman (1998) formulated the dilemma: “Winners Take All: The Politics of Partial Reform in Postcommunist Transitions.” The state enterprise managers and their accomplices were the main culprits, opposing early and radical reforms because they could make fortunes on delaying and distorting the reforms, and under the fragmented political system only small interest groups could successfully pursue collective action (Olson 1971).

The political dilemma of Russia’s postcommunist transition was that the ineffective budding democracy could not mobilize the people against the rent seekers in favor of more radical reform, as in Central Europe and the Baltics (Åslund 2007a).

Unfortunately, the reformers did not realize that the seemingly moderate state enterprise managers would be their main opposition. Many managers had opposed the August 1991 coup and welcomed Yeltsin. Reformers thought them progressive, but the managers simply wanted to make money on the collapse of the old system. They could enjoy freedom and control their state enterprises as their own property (Dobbs 1997). After the transition to a market economy had started, the interests of the state enterprise managers diverged from the reformers because the managers favored a protracted and socially costly transition, with a maximum of rents being diverted to them. Yeltsin never understood this and damaged his reforms by veering over to their side in the spring of 1992. But the leading reformers did not understand, either — they tried to coopt and divide the state enterprise managers rather than defeat them.

On macroeconomic stabilization, no common ground existed between the reformers and the rent seekers, and any attempt by the reformers to reach a compromise just delayed stabilization and aggravated inflation. Fedorov’s aggressive stabilization policy in 1993 was more successful than Gaidar’s attempts to find compromises in 1992, but Fedorov benefited from the reforms already undertaken, the diffusion of rents, and the presence of the IMF.

By contrast, Chubais [who was Minister of Privatization] succeeded because privatization allowed room for compromise: the state managers could accept giving away some of their quasi property rights to other stakeholders in exchange for legal guarantees for the rest of their ownership.

Aslund’s statements regarding privatization as being the tool used to co-opt state enterprise managers into the 1995’s efforts for macroeconomic stabilization are supported by Shleifer’s work:

Initially, it was well compensated with export privileges and tax exemptions for the costs it absorbed. But in late 1995, as the growing rate of tax nonpayment by profitable energy-sector enterprises attracted international attention, some of these privileges and exemptions were gradually withdrawn.

Two factors explain the sector’s continuing cooperation.

First, the government allowed managers of the major energy-sector enterprises considerable freedom to privatize and manage the companies in their own way. Forty percent of shares in Gazprom remained in state ownership, but they were given to the company’s chief executive, Rem Vyakhirev, to manage in trust.

Moreover, the banks that had acquired some of the most attractive energy companies in trust in the loans-for-shares program did not wish to make trouble until they had gained full control of these assets.

The sector’s second and main motivation to avoid provoking a crisis was the fear of possible electoral consequences. Both the Communist leader Gennadi Zyuganov and the nationalist Aleksandr Lebed had made clear in their presidential campaigns that a government of the opposition would seek to reestablish control over the energy sector and extract even larger concessions. The oil and gas bosses had a strong interest in keeping the current elite in power.

The symbol of this alliance was Viktor Chernomyrdin, the prime minister and former Gazprom chairman. Chernomyrdin’s conversion from an advocate of inflationary credits and price controls when he first came to power in late 1992 to a guarantor of financial stability in 1995–96 dramatizes the sector’s growing recognition that it was the biggest winner from market liberalization.

Shleifer also states that the “broad handout of property rights to industrial managers during privatization split what had been a united front of most of industry against the government’s stabilization plans. A wedge opened between the managers of profitable companies and those of unprofitable enterprises. While the former wanted to attract foreign investment and increasingly favored stabilization, the latter continued to demand large subsidies… [T]he energy sector barons, co-opted in part by benefits from privatization and in part by generous export concessions, played an important role in appeasing selected enterprises, farms, and public-sector organizations by extending sales credit to them as they were increasingly cut off from direct government aid. This helped to disorganize the resistance to tight monetary policy and to reduce inflation in 1995.”²⁷

The Rise and Fall of State Mangerial Rule (1994–1995)

Besides price liberalisation which itself was partial and the mass privatization that took place in 1991–1992, Russia did not carry out a comprehensive radical reform program — Aslund states that only “some reform measures were radical, but virtually all of them were successful, while all ‘moderate’ policies failed… [T]he reformers were in power for only half a year, from November 1991 until May 1992. How can all of Russia’s problems be blamed on them? This is a baseless accusation. From June 1992 until March 1998, the government was dominated by state enterprise managers. They did issue more subsidies and impose more regulation in the name of industrial policy, which delayed economic growth in Russia until 1999.”²⁸

Out of all the interest groups, the state enterprise managers were the best organized. They were able to generate a great deal of rents and political influence during the period of economic transition. Like mentioned before, they opposed macroeconomic stabilization and pushed for price regulation that “favored high prices on their output, but state managers in energy and agriculture called for low state regulated prices for their produce, because they were traders, making their fortunes on buying these products cheaply and selling them at high international prices for personal benefit. Meanwhile, they claimed they protected the living standards of the population.”²⁹

Under the rule of the state enterprise managers, an omnibus was passed in 1993 that allocated “large centralized credits, plan targets for 10 major agricultural products (giving the agrarians bargaining chips against the state), and some trade monopolies.”³⁰ The metallurgical industry which was an industry controlled by the state enterprise managers received tax-exemptions that amounted to “2 percent of GDP… main trick was to exempt metal trade from the value-added tax and foreign trade taxes through barter deals. Metallurgical companies used transfer pricing, buying inputs abroad for a higher price than the ruling world market price and selling them at a lower price, leaving their profits in a trading company in an offshore tax haven (Bagrov 1999).”³⁰

When the question of privatization came up which was a byproduct of the reform government, Anatoly Chubais (one of the last reform economists remaining) selected by President Yeltsin to remain as the Minister of Privatization in the state enterprise manager dominated government attempted “to limit their share of ownership to about one-fifth after the voucher auctions, [however] the managers still controlled most enterprises by acting as proxies for the 40 percent of shares usually held by their employees.”³¹

The state managers “delayed enterprise restructuring. Increasingly, managers paid neither their taxes, bank loans, nor suppliers, accumulating large arrears. They hoarded workers as in Soviet times to extract more subsidies, which impeded the expected unemployment, but they cut real wages and caused chronic wage arrears and poverty. Many state-owned and insider-privatized enterprises came to a standstill in spite of large capital investment financed with subsidized state credits.”³²

Out of all the state enterprises, Gazprom — the firm that had a state-sanctioned monopoly on natural gas and oil was the biggest corporation in Russia. Viktor Chernomyrdin its de facto owner obtained control of the firm through the process of “spontaneous privatization” as mentioned earlier in this article — becoming its de facto owner when the Ministry of the Gas Industry responsible for overseeing it was abolished in 1989.

When Yeltsin appointed Chernomyrdin as deputy prime minister for energy in May 1992, he had to leave Gazprom, but he passed on the top job to his protégé, Rem Vyakhirev. As deputy prime minister and later as prime minister, Chernomyrdin continued to protect Gazprom’s interests to quite an extraordinary extent. In November 1992, a presidential decree transformed Gazprom into a joint stock company, strengthening its legal status.

Almost all other old industrial ministries and enterprise associations were divided into individual enterprises as an initial step toward corporatization and privatization, but Gazprom was exceptionally corporatized as one company that included literally all enterprises and institutions dealing with gas: producing companies, refineries, pipelines, trading companies, the gas foreign trade company, all regulatory agencies, teaching and research institutes, and even 200 state farms. It employed about 400,000 people.

After the Congress of People’s Deputies was dissolved in September 1993, the reformers carried out all kinds of deregulation that had previously been politically impossible, but Chernomyrdin sponsored a decree that guaranteed Gazprom a complete monopoly on the production, sale, transport, and export of natural gas. The gas industry was the most monopolized and regulated industry in Russia, while all other industries had undergone substantial liberalization. Natural gas exports were subject to licenses and quotas, but Gazprom itself was exempt from the export tax, some import tariffs, and the value-added tax (VAT) (Åslund 1995).

All Russian energy prices were regulated and extremely low in 1992. As head of Gazprom, Chernomyrdin did not advocate higher gas prices. Nevertheless, in 1994, he stated that a fundamental mistake of the first reform government was its failure to liberalize energy prices at the beginning of the reform. The price of natural gas remains regulated, and it has been raised only gradually, reaching one-fifth of the European import price by December 1993 (Åslund 1995, 158–61). After considerable fluctuation, the gas price remained about one-quarter of the European import price in 2007. Its pricing was nontransparent, and price regulation and discrimination persisted.

The value of the tax exemptions awarded in late 1993 amounted to 1 to 2 percent of GDP, when Gazprom’s share of Russian net value added was about 8 percent of GDP (Bagrov 1999). Russia’s wealthiest company was barely paying any taxes. Gazprom’s gas production declined by only 4 percent (BP 2007), while the official decline in Russia’s GDP was 44 percent from 1989 to 1998 (UN Economic Commission for Europe 2004, 80), although the real GDP decline was probably only about half of the official total (Åslund 2002)… As a monopoly, it prohibited both domestic oil companies that produced associated gas and Turkmenistan from transporting their gas through Gazprom’s pipelines… Given the monopoly and the arbitrary pricing, no domestic market could develop. Even in 2007, gas was allocated by administrative fiat as in Soviet times (Åslund 1995, 159; Olcott, Åslund, and Garnett 1999).

Gazprom was privatized in a unique order in 1993–94. Its management used the voucher auctions to privatize almost 40 percent of Gazprom shares for an implied price of about $100 million (Klebnikov 2000, 134–35; Stern 2005, 170–71). Of all Russia’s privatizations, this was the biggest giveaway, because these shares cost one thousand times more, $100 billion, in 2006. In 1994, Prime Minister Chernomyrdin appeared to have time for nothing but Gazprom privatization. The stocks were given away for a nominal fee to Gazprom managers, senior officials, and employees — altogether half a million people — but not at all evenly.

At the time, it was rumored that Chernomyrdin and Vyakhirev each received 5 percent of the shares, which Chernomyrdin publicly denied. If that were actually true, and if they still possessed these shares in 2007, each would own about $13 billion. Cleverly, Gazprom gave stocks to many top people in the Kremlin, wedding them to the enterprise’s interests.

To make sure that they did not lose control over the company, no stocks could be traded without permission from the Gazprom board, and they could be owned only by Russians. Furthermore, nearly 60 percent of the company stayed state-owned or owned by Gazprom subsidiaries. In 1996, 1 percent of the shares was sold in the West, where they traded at a much higher price until 2006, when domestic and foreign shares were unified. Lukoil and Surguteftegaz, two large oil companies, were also privatized by their skillful managers, Vagit Alekperov and Vladimir Bogdanov, respectively…

At the end of the 1990s, Gazprom management opted for large-scale asset stripping, transferring large properties such as gas fields to Itera and other companies owned by close relatives of the leading Gazprom managers (Stern 2005, 22–24). This took place after Chernomyrdin had been dismissed as prime minister in March 1998, and Gazprom management had good reason to fear losing control over the corporation.

Gazprom was Russia’s foremost rent-seeking machine, but it remained respected for several reasons. It kept up production, allowing Gazprom to continue delivering gas to enterprises and households even when it was not being paid. It was Russia’s largest exporter. When much of Russia’s heavy industry plunged into murderous shootouts, Gazprom retained a veneer of peace and order. It was an idyllic Soviet theme park with wonderful holiday homes and social benefits.³³

Such a parasitic existence existence had its days numbered — Russia suffered what would come to be known as “Black Tuesday” occurred on October 11th, 1994 which resulted in the exchange rate of the ruble decreasing “precipitously by 27 percent in a single day. One year earlier, the exchange rate was of little concern, but now it had assumed real economic significance, because Russia had become a market economy. Powerful economic interests had become used to a reasonably stable and predictable exchange rate, and its mismanagement — or more likely, manipulation — aroused a popular outcry.”³⁴

Leading economic policy experts for the state manager run government were removed by Yeltsin, and Gerashchenko who had been the state managers’ hand-picked director for the Central Bank was also removed (mentioned earlier in this article as an advocate for loose monetary policy). Chubais who was appointed by Yeltsin to be Minister of Privatization was also given the position of Deputy Prime Minister, and managed to reduce the budget deficit “from 10.4 percent of GDP in 1994 to 6.6 percent in 1995 (figure 4.2), but revenues declined by 3.6 percent of GDP as budget constraints tightened.”³⁵

Similar to Shleifer, Aslund states that these cuts in state subsidies and the move towards macroeconomic stabilization were only made possible because the reformers were able to divide the business community and were supported by “the rise of the bankers who thrived on the high yields of treasury bills” and “the decline of the state enterprise managers who lived on other forms of rents.”³⁶

The sudden and radical cut in subsidies was quite a blow to the old rent seekers. They were left in disarray, which demonstrated that the smaller their rents, the less their political power. Financial stabilization also divided the powerful Association of Russian Banks. When the interbank market dried up in the fall of 1995, financially strong banks did not call for state support but tacitly favored the bankruptcy of their competitors. A new generation of private bankers took over from the old state bankers, facilitating change (Dmitriev et al. 1996). Similarly, the old red directors lost ground to new businessmen. This is how shock therapy reforms should work. By changing the paradigm and the rules of the game, businessmen were enticed to switch from rents to profits, thus breaking up the rent seeking lobbies.³⁷

However, this stability would be temporary as the same treasury bills which were used to buy up the support of the banking sector helped fuel another macroeconomic crisis. Aslund adds to his previous statements by writing that the “[r]ent seeking through extremely high treasury yields was no exit from fiscal jeopardy but a trap. Successful reforms, as in Poland and Estonia, beat rent seekers by changing the rules of the game once and for all, enticing businessmen to opt for profits rather than new rents. The purpose of reform is to defeat rent seeking and establish a more productive set of incentives. It would be both illogical and defeatist to think that one can make people honest only by bribing them...”³⁸

Even though the state manager run government had to implement a policy of macroeconomic stability as was seen in 1995 — they went back to doing exactly what they did before and tried to halt economic transition halfway. No radical economic reforms were pursued in period of 1994 and 1995, and the government contained no reformers other than the aforementioned Chubais. The only two significant acts of reform in 1994 and 1995 were spearheaded by Chubais.

The first was the aforementioned voucher privatization which was in large part co-opted anyways by the state managers and corrupt insiders as mentioned earlier. The other reform was “the stabilization program adopted in March–April 1995 as a standby program with the IMF. This was Russia’s first successful stabilization program, because it involved the first serious cut in the fiscal deficit since the beginning of the reforms in 1992. It had become possible thanks to an abatement of rent seeking, which had been prompted by the accumulated reforms in 1992 and 1993 as well as by attrition caused by rising market forces. Still, the fiscal adjustment was neither sufficient nor sustainable, because nothing had been done to the tax system or fiscal federalism.”³⁹

The Rise of the Oligarchs (1996–1998)

The rule of the state managerial class was coming to an end as Aslund writes that the state enterprise managers were unable to adopt to the new market conditions imposed by the macroeconomic stabilization efforts put into place in 1995:

The old managers failed for many reasons. They did not know how to run their companies under the new market conditions. Output continued to fall, and many of them were able to adjust only by cutting costs. They ran up notorious wage and interenterprise arrears. The ample rents of 1992 and 1993 had abated, and direct budgetary subsidies were insufficient to keep the managers afloat. Most of them knew little about finance and they were contemptuous of marketing. They failed to keep up with the changing nature of rent seeking. Insider privatization had given them ownership control over their companies, but mostly through minority posts. Gradually, one after the other, these substandard managers were ousted by outside raiders, exactly as the privatizers had hoped.

What replaced them were the Oligarchs — the Oligarchs originated from the same banking sector which was given life by the partial reforms of the Gorbachev period of Perestroika, they were able to obtain a large accumulation of capital generated from both their inflationary rents as well as high treasury yields. Aslund described them as “the first products of transition, and Russians received the oligarchs with awe and fascination. Their outstanding talent was financial magic: to make money out of anything, by any means, and they changed their techniques of enrichment almost as often as their beautiful women changed clothes. They made money on stocks and bonds and of course also on the state rather than on production.”⁴⁰

Aslund expounds on what was said before stating many of the Oligarchs were able to expand to industries beyond finance because of treasury bills which had a real yield “around 100 percent a year until 1998. The bankers were not interested in inflation as the industrialists had been, but they favored a large budget deficit that maintained the government’s hunger for credits and kept the real interest rates high (Treisman 1998). They also made money as ‘authorized banks,’ handling the accounts of state agencies that did not claim adequate interest for their deposits.”⁴¹

The oligarchs were products of the prevailing conditions, which changed at an infuriating speed. Most of them had set up early cooperatives in 1988, doing all kinds of trading. Some had taken off with the importation of computers from the West, and most of them had become millionaires by exporting oil. Next, they entered banking. They usually established new banks and attracted some capital from old state banks. Invariably, they benefited from cheap credits from the Central Bank of Russia. Only to a very limited extent did they engage in the spontaneous privatizations before 1993. In the early 1990s, successful businessmen traded and “sat on the pipe,” tapping the cash flow of state enterprises rather than managing or owning companies…

Everything changed with privatization. The budding oligarchs were pioneers who bought hundreds of thousands of privatization vouchers that they used at voucher auctions to buy whatever stocks they could get. At this stage, it would have been foolish to have a strategy. It was difficult enough to keep up with when and where voucher auctions were held, how much would be sold, and at what price. Small bands of treasure hunters chased good stocks all over the country. By necessity, stock prices were ludicrously low at the voucher auctions. After the auctions were completed in 1995, the new enterprise owners looked at their catch and started considering business strategy. Conspicuously, Bank Menatep ended up with control over 200 sundry industrial companies. Not knowing what to do, Menatep established a holding company, which the Menatep owners with characteristic self-confidence named Rosprom (Russian industry).⁴²

Aslund explains that the origin of the “loan for shares” privatization program that took place in 1995 and onwards was an idea conjured from the Oligarchs themselves — it was seen as both necessary by the Yeltsin Government to end the power of the state managers, get much needed revenue and earn their support in the 1996 Elections:

[Potanin — the Minister of the Economy] proposed a debt-for-equity swap. He formed the Consortium of Russian Commercial Banks, which included six leading oligarchic banks. They offered to lend the cash-strapped Russian government $2 billion for one year against a collateral of big stakes in some of the country’s best companies. The banks would manage the companies in trust, and if the state did not repay the credits one year later, the bankers would be entitled to sell their collateral, also to themselves. The proclaimed intention was that they would compete in auctions about offering the largest credit for each company. Yeltsin signed the decisive decree on August 31, 1995, and the auctions took place during November– December 1995 (Kokh 1998, 104; Klebnikov 2000, 198)…

However, [Chubais] had been forced to make two concessions: These auctions were not open to foreigners, and the prices would by necessity be very low. He reassured me that the auctions would be open to Russian competitors, but that did not work out either.

Originally, the bankers proposed 43 lucrative corporations for privatization, but most of them resisted ferociously. Eventually, 16 companies were put up for auction, of which four attracted no bid. The 12 companies sold included five oil companies (Yukos, Sibneft, Sidanko, Lukoil, and Surgutneftegaz), Norilsk Nickel, two steel corporations (Novolipetsk and Mechel), two shipping companies, and the oil-products trader Nafta Moskva (Kokh 1998, 108–10).

Several of these auctions did not change control. The managers of Lukoil and Surgutneftegaz used this opportunity to expand their ownership. In reality, only three companies were controversial — Yukos, Norilsk Nickel, and Sibneft (Kokh 1998, 115–30) — and all the writing about the loans-for-shares auctions discusses these three corporations. Oneximbank bought Norilsk Nickel for $170 million. Menatep acquired 86 percent of Yukos’ shares for $309 million. Berezovsky and the new oligarch, Abramovich, bought a majority of Sibneft for $100 million (Kokh 1998, 121, 123, 126; Freeland 2000; Hoffman 2002).

These sales aroused sharp criticism from the outset. As usual, the oligarchic banks were divided. Oneximbank, Menatep, and Stolichny were on the inside, being challenged by Rossiisky Kredit, Inkombank, and Alfa Bank on the outside. The banks that bought these companies organized the auctions themselves. Russian competitors offered higher bids, but they were disqualified with the argument that they could not pay as much as they promised. The rivals were powerful and discredited the winners. Many Russian reformers parted with Chubais over these auctions. Western organizations that had participated in prior Russian privatizations stood aside and took exception, and the Russian reformers lost their luster in the West. Naturally, the communists and nationalists in the Duma seized upon these controversial privatizations. The communists set up a special Committee to Investigate Privatization and Punish the Guilty (Blasi, Kroumova, and Kruse 1997, 75)… As Chrystia Freeland (2000, 170) pointed out: “Loans for shares was revolutionary because it…took companies away from their red directors and gave them to a handful of thrusting entrepreneurs.”

This privatization formed a new political alliance between reformers and oligarchs: “At heart, the loans-for-shares deal was a crude trade of property for political support. In exchange for some of Russia’s most valuable companies, a group of businessmen — the oligarchs — threw their political muscle behind the Kremlin” (Freeland 2000, 169). The oligarchs were neither liberals nor reformers. They had made their money on rent seeking, opportunism, and ruthlessness. An underlying rationale in the loans-for-shares scheme was that the oligarchs would hold the enterprises in trust for one year. Only after the presidential elections in mid-1996 would the oligarchs be allowed to buy the shares. These privatizations were a tool to ally the quixotic oligarchs with Yeltsin in the upcoming presidential elections (Freeland 2000, 180–81).

The Bankers’ War of 1997

Yeltsin’s gamble was a success — he was re-elected President of Russia and appointed a new government filled with reformers including Boris Nemtsov who was a popular regional governor. Yeltsin’s government declared that it would try to enact the radical economic reforms that they were not able to implement in 1991 to 1993, and stated that “the period of ‘bandit capitalism’ was over and that the time had arrived for a normal, honest market economy or ‘people’s capitalism.’”⁴³

The new reform government believed that it had enough popularity to now overrule the Oligarchs who helped them get elected. They first “attacked Gazprom, Russia’s wealthiest company, which was finally registered as a monopoly, and the reformers tried to tax it normally. They also questioned the management’s right to vote for the government’s shares (Slay and Capelik 1997). An equally unpopular idea was to force the oligarchs to pay taxes. Some of them were already paying millions of dollars in personal income taxes, but most did not (Fedorov 1999a, 199–200). The reformers insisted that Russia would hold open privatization auctions for the remaining big state companies. Nemtsov also wanted to deprive the oligarchic bankers of their privileges as authorized banks to hold state funds for minimal interest payment.”⁴⁴

The oligarchs, however, knew they had helped Yeltsin to win the presidential elections. Now it was payback time. The tension between the reformers and oligarchs came to a crunch in July 1997. The government had decided to privatize one quarter of Svyazinvest, a state holding company that held controlling stakes in all Russia’s regional wireline companies. Gusinsky, who had been left out of the loans-for-shares deals, had long eyed Svyazinvest and considered it promised to him. He formed a consortium with Fridman from Alfa Bank, who had also been excluded from loans-for-shares. Fridman asked: “Why did [privatizations] have to become fair at this particular moment?” (quoted in Freeland 2000, 280). Their consortium was supported by Berezovsky, although he had no direct commercial interest. He opposed the reformers because Nemtsov had blocked him from becoming chairman of Gazprom, and he favored corruption. In addition, he wanted to be the senior oligarch.

However, Potanin decided to compete in the Svyazinvest auction, and he was not deterred by all the other major oligarchs ganging up against him. The auction took place in Moscow on July 25, 1997, and Oneximbank with partners won with a bid of nearly $1.9 billion. This was several times more money than the government had received for any prior privatization, and it was the most transparent and honest large privatization auction Russia ever held. One of Potanin’s partners, George Soros, later exclaimed: “It was the worst investment of my professional career” (quoted in Klebnikov 2000, 282), clarifying that the price was too high.⁴⁵

Outraged by the fact that they were bested by one of their own and what felt like betrayal from the Yeltsin Government, the Oligarchs declared what would be known as the Bankers’ War of 1997. Gusinsky and Berezovsky’s media empires began an all-out propaganda campaign — alleging that the privatization auctions had been corrupt and dug up dirt on Chubais’ protégé, Minister of Privatization Alfred Kokh, “had received a hefty advance of $100,000 for a book about Russia’s privatization from a company related to Oneximbank. In addition, he was personally entertained by Potanin. Yeltsin sacked Kokh in short order.”⁴⁶

Later, a suspected murder sponsored by the Oligarchs resulted in the death of Deputy Mayor for Privatization Mikhail Manevich who died in his car due to fatal gunshot wounds inflicted by a sniper.⁴⁷ Media assassinations of members of the reform government continued, and resulted in the resignation of the successor for Minister of Privatization.

In the end, the reform government was in paralysis unable to carry out any significant reforms as a “coalition of communists and nationalists held a majority in the State Duma, and they did not accept any reform legislation. The regional governors, who were powerful and deeply entrenched in corruption, could also block any reform legislation.”⁴⁸ Gaidar, a name familiar now to the economic reform efforts remarked that “[w]e did not foresee how short-sighted the strategy of the so-called oligarchs would be, to what degree they would prove unable to understand their own self-interest” (quoted in Freeland 2000, 274).⁴⁹ The Oligarchs won — the outcome of the Bankers’ War of 1997 was a lame duck Yeltsin who could not continue his ambitious agenda of creating a functioning market economy.

The Causes of the Financial Crash of 1998

While Russia's agreement with the IMF in 1995 did bring down inflation, the country’s fiscal policy was too loose whereas monetary policy was strict which forced the government to borrow heavily to finance its expenses. The “large budget deficit, primarily through domestic treasury bills at outrageous real interest rates lingering around 100 percent per annum. Access to the treasury bill market was limited to privileged Russian banks, excluding both foreigners and households, making it a bonanza of rent seeking. The IMF insisted on opening this market to foreign investors, which lowered treasury bill yields, but it also exposed Russia to a dangerous dependence on short-term foreign capital, attracted by the abnormally high yields.”⁵⁰

Despite the budget deficit and continued decline in industrial output, Russia being an emerging economy saw the stocks of its capital intensive industries surge rapidly upwards especially after privatization. This to foreign investors looked very attractive.

The freely floating exchange rate showed a tendency to rise, so in the summer of 1995 the authorities introduced a currency band for the ruble exchange rate to impede its rise, prescribing a moderate devaluation instead. This band inspired a false sense of security.⁵¹

In 1995, just before the 1996 Election — distributing “preelection gifts, the government let the budget deficit rise from 6.6 percent of GDP in 1995 to 9.4 percent of GDP in 1996 (figure 4.2). The real yields of the treasury bills peaked at 150 percent a year before the presidential elections, as the government tried to sell more bills than the market was prepared to buy given the political risks. Almost 4 percent of GDP went to the payment of yields on treasury bills (Illarionov 1998b).”⁵²

However, the impetus for the Russian Financial Crash of 1998 came when the IMF extended further credit to the Russian Government — creating false hope in foreign speculators who dumped money into Russian stocks as Aslund explains below:

Although nobody in the government was concerned about reform, in the spring of 1996 the IMF concluded a three-year loan program with Russia, an Extended Fund Facility with $10.2 billion in financing. This program lacked all credibility, because it demanded that the budget deficit be slashed to 4 percent of GDP, which was never a serious proposition. This was all too obviously a G-7 political decision to secure President Yeltsin’s reelection. Germany and France gave Russia substantial additional credits, allowing the Russian government to increase the budget deficit further.

Yeltsin survived, but these unconditional credits harmed Russia’s economic policy. The soft IMF agreement convinced foreigners and Russians alike that Russia was too big and too nuclear to fail. In September 1996, the IMF delayed one credit tranche, but from that time and throughout 1997 the IMF had little leverage, because the election results and the IMF agreement had unleashed an extraordinary inflow of private foreign portfolio investment (Odling-Smee 2004, 25). Russia was set for a stock market boom that could only lead to a bust.

Foreign portfolio investment skyrocketed from a respectable $8.9 billion in 1996 to an incredible $45.6 billion in 1997, or 10 percent of GDP (RECEP 1999). Roughly half of the foreign portfolio investments went into federal government bonds and the other half into other bonds and stocks. 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 stock of treasury bills in the summer of 1998 amounted to some $70 billion, of which foreigners held some $30 billion. In addition, substantial amounts of corporate, regional, and municipal bonds had been issued.

In July 1998, the accumulated foreign portfolio holdings were at least $65 billion or nearly 15 percent of GDP. In addition, international financial institutions had provided the Russian government with more than $20 billion, or 4.5 percent of GDP, in loans. Ironically, Russia was flooded with foreign financing mainly private but also intergovernmental — after serious attempts at economic reform had faded.

Until October 1997, foreign investors had no reason to complain. Russia was the best performing stock market in the world in both 1996 and 1997 with the stock indexes increasing more than six times from January 1996 to October 1997 (figure 5.1). For foreign investors, Russia had become a magic money-making machine…

The foreign portfolio investments contributed to the magnitude of the Russian financial crash, and these loans to the Russian government diminished the need for the state to collect taxes or cut subsidies. The conditionality of the IMF loans was ineffective in the presence of such large, unconditional private portfolio investments. The Russian bankers focused on the domestic treasury bill market, and encouraged by the World Bank and the European Bank for Reconstruction and Development (EBRD) they borrowed heavily in foreign currencies, exposing themselves to serious currency imbalances. This was a fools’ paradise, and only fools did not buy treasury bills and Russian stocks.

Another cause for the government’s large deficit was the blatant theft of tax revenues by state enterprises, local and regional governments which were facilitated by the barter trade as Aslund demonstrates below:

Strangely, barter and nonpayments did not go away in this surplus of money but proliferated. By 1998, about half of all interenterprise payments were made in barter, about one quarter in money surrogates, and only onequarter in money (figure 5.2). This was not the desired monetization of the Russian economy. The proliferation of barter was confusing and challenging, and many alternative explanations were presented. Communists complained about a shortage of money, requiring additional emissions, but the issue was not scarce supply of money but a lack of demand. Clifford Gaddy and Barry Ickes (1998, 2002) provided the most convincing explanation. They showed that a well-entrenched system offered many actors strong incentives to use barter, because barter and other noncash payments facilitated tax avoidance and evasion.

Barter and offset prices were about twice as high as prices in cash, and businessmen could extract tax discounts by paying with offsets (Commander and Mumssen 1998). If a construction company had not paid its taxes, it offered to build something for the regional government, thus winning an often unplanned public investment project.

Offsets were by their nature discretionary negotiations between big businessmen and government officials about large amounts of money, imbued with corruption.

The masters of the barter economy were the big state monopolies, Gazprom and Unified Energy Systems, the state-owned holding company for regional public utilities. In 1996–97, only 7 percent of retail gas purchases were paid in cash, and arrears abounded (Slay and Capelik 1997). Big industrial enterprises used barter to subdue small enterprises. Forty percent of the barter trade was perceived as involuntary, meaning that an enterprise was compelled to accept a payment in products it did not want (Aukutsionek 1998). A second group of beneficiaries were regional governments, which used offsets to divert tax revenues from the federal government to themselves, receiving 60 percent of taxes in money surrogates, compared with 25 percent for the federal government (OECD 1997, Illarionov 1998a). Third, old loss-making, Soviet enterprises that were reluctant to adjust to market conditions were kept alive by subsidies extracted through barter.

The post-Soviet nonmonetary economy was a complex relations economy, benefiting big enterprises, old Soviet enterprises, and regional officials. The losers were the national economy, the consumers, small and medium-sized enterprises (which lived in the overtaxed cash economy), and the federal government (which was starved of revenues). A monetized economy is transparent and competitive, offering fewer advantages to large and old enterprises. Barter was an important structural cause of the financial crash of 1998.

All of the money which had been poured into Russian stocks to create a boom then led to big bust when the 1997 Asian Financial Crisis hit in the summer of that year, and reached Russia by October.

On October 28, the Russian stock market suddenly fell from its near peak by 19 percent, and the international credit market tightened. The government was completely unprepared. During that month, Berezovsky worked with the communists in the State Duma and with Prime Minister Chernomyrdin to increase the budget deficit to over 8 percent of GDP in 1997 (figure 4.2), not least to undermine the reformers in government. Given that the government had just expanded the deficit, it failed to tighten its fiscal policy until February, and real interest rates shot up to over 100 percent a year again…

The only mystery about Russia’s financial predicament was that it had not resulted in a serious crash earlier. For years, the country had maintained a budget deficit of 8–9 percent of GDP. Even in 1998, it was 8.2 percent of GDP (figure 4.2), because the government had refrained from cutting enterprise subsidies. A study by Pinto, Drebentsov, and Morozov (1999) estimated that total Russian budget subsidies amounted to a staggering 16.3 percent of GDP in 1998, of which 10.4 percent of GDP was extracted through barter and nonpayments and 5.9 percent was direct enterprise subsidies. Federal-regional fiscal relations aggravated these problems because most of the revenues stayed with the regional governments that provided the bulk of the enterprises subsidies, whereas the federal treasury was responsible for all debt service on the fast-growing and unsustainable short-term government debt.

By late May 1998, the creditors finally got scared and withdrew on a large scale, and the dollar-pegged exchange rate came under severe pressure. Russian bankers started withdrawing their funds from the country, while foreigners were still attracted by the extraordinary bond yields. Even so, the central bank was swiftly losing its limited currency reserves defending the exchange rate. At this stage, a devaluation would have bankrupted half the banks because of their adverse currency balances.⁵³

When the IMF offered to provide a credit package of $23 billion — the State Duma (Parliament) refused to pass the necessary revenue reforms and so in reality only $4.3 billion went through. Regardless of the amount, no amount of credit could be extended to cover the country’s widening budget deficit.

The Russian finances could no longer be saved without devaluation or a default. On August 17, 1998, the government did both. It defaulted on its domestic debt of some $70 billion, and the value of the ruble soon fell by three-quarters. In addition, the government declared a moratorium on Russian banks’ foreign payments, which in effect became a general freeze of bank accounts. Once again, ordinary Russian bank savers lost their money, usually about two-thirds of their deposits, and they had to wait in humiliating lines outside the banks for days hoping to rescue some of their savings. Inflation that had fallen to the single digits surged to 85 percent for 1998 as a whole. The Russian stock market hit bottom with a staggering fall of 93 percent from its peak in October 1997 until early October 1998 (figure 5.1). One Western investment banker said that he would rather eat nuclear waste than invest in Russia again (Freeland 2000), but this was of course the ideal time to invest.

About half of Russia’s commercial banks went bankrupt, including all the big oligarchic banks save Alfa Bank. The oligarchs’ spell as bankers was over and their very survival was under a cloud. The big questions for the country were whether the market economy was over, whether the communists would come back, and whether hyperinflation would erupt. The shock was enormous and so was the sense of national failure. In Moscow, somebody put up unsigned posters with the words: “Nobody will save Russia apart from ourselves.” In jest, one of the posters had been signed, “Michel Camdessus,” the managing director of the IMF. Russia’s self-confidence had hit a new low, but Russians realized they had to take their responsibility.⁵⁴

Three major interest groups pushed their country into this abyss which Aslund identifies below:

The main culprits were the oligarchs. The bankers had encouraged the large budget deficit and thrived on the treasury bills, although many of them now suffered badly themselves. Berezovsky had even been talking down the Russian market (Klebnikov 2000, 281). Some oil barons, including Berezovsky, had campaigned for devaluation, although they knew that this would lead to the bankruptcy of most banks. The oil producers wanted lower production costs in rubles and thought little about other consequences (Alekperov 1998).

Second, the Russian State Duma, which was dominated by the communists, refused to accept a government proposal to move from a value added tax based on payments to accrual basis in July 1998, which would have taxed barter. Nor did the Duma agree to transfer any regional revenues to the federal treasury. These two votes by the Duma triggered the financial collapse.

Third, behind these decisions by the Duma stood the regional governors, who resisted any transfer of their funding to the federal government, although regional revenue was almost one and a half times as large as the federal revenues, and much of it was spent on discretionary enterprise subsidies.

Assessment of the Oligarchs — Post-Financial Crisis of 1998

The oligarchs had enriched themselves as traders, primarily trading oil and metals. At the end of communism, they were all bankers and benefited from inflationary profits. In 1993–94, they thrived on the voucher auctions, opportunistically accumulating stocks in a large number of enterprises. From 1995 until June 1998, they made huge fortunes on domestic treasury bills with high yields. A breakthrough for the oligarchs was the loans-for-shares privatizations, even if only three significant companies — Yukos, Norilsk Nickel, and Sibneft — changed controlling owners. The newly rich entrepreneurs showed that they could beat the most powerful old state enterprise managers. The rise of the oligarchs marked the ascendance of ownership over the management of assets, which profoundly changed the nature of the Russian economy…

The financial crash of August 1998 brought about fundamental changes for the oligarchs. Their banks were most exposed to the financial collapse because they were heavily invested in treasury bills that defaulted and they had taken large foreign loans that they could not pay back after the devaluation. Of the big banks, only Alfa Bank and MDM had sold their treasury bills in time and survived. Another effect was the rise of the commodity producers, that is, oil and metals. Out of 26 Russian billionaires identified by Forbes magazine in 2005, 12 had made most of their money on metals, nine on oil, and two on coal (Kroll and Goldman 2005). Another major change was that the oligarchs developed lucid corporate strategies. Their corporations remained conglomerates, but most of them concentrated on approximately three core industries. They sold off accidental assets that they had assembled during the privatization.

The ideal business strategy was to have been a banker thriving on treasury bills until May 1998 and then sell the treasury bills and sit on foreign cash until after the August crash. In the fall of 1998, the trick was to buy commodity-producing companies cheaply on the secondary market. Some rising oligarchs did exactly that, notably the owners of MDM Bank, Andrei Melnichenko and Sergei Popov, who were only in their 20s. In June 1998, they smartly sold all their treasury bills, and after the crash they started buying up privatized coal mines, eventually accumulating onethird of Russia’s coal production in their company SUEK. They turned their coal mines around in no time, decriminalizing them, laying off workers, boosting coal output, and thus achieving good profits without state support in an industry that had lived on subsidies.

In late 1999, Oleg Deripaska and Roman Abramovich, both in their early 30s, bought most of Russia’s aluminum production from the infamous brothers Mikhail and Lev Chernoi (victors of the bloody aluminum wars), and they formed Rusal. Thus, a new generation of even younger oligarchs emerged who did not suffer from the (unjustified) stigma of the loans-for-shares privatizations. Purchases of already privatized enterprises were politically much more acceptable than purchases directly from the state, which were invariably seen as corrupt…

Other large business groups looked similar. Usually, they had an oil or metals company as their cash cow. They poured the cash into manufacturing, consumer industry, or retail trade…

Economically, the oligarchs went through a gradual transformation from rent seekers to profit seekers, from parasites tapping the assets of the state to full-fledged owners and investors. As conditions stabilized, their time horizon grew from one day to the long term. Until 1998, many of them could be criticized for asset stripping and the dilution of minority shareholders’ ownership, but since 1999 that has hardly been true. The oligarchs have invested heavily; they have displayed large profits; and many of them have paid substantial dividends to minority shareholders. True, they have been more greedy and aggressive than most businessmen, but isn’t that what capitalists are supposed to be? Increasingly, the Russian oligarchs have become more like big businessmen in Western countries, only more dynamic, successful, and colorful…

Almost all the oligarchs were not only owners but also managers of their big enterprises. They turned around Russia’s old heavy industry, especially the oil and metallurgical industries, using many talents. A first precondition for the successful management of a big Soviet enterprise was good relations with the Kremlin, that is, the federal government, as well as with the regional governor.⁵⁵

False Comparison of China and Soviet Union on Economic Reforms

After reading this article, one will come to the conclusion that Russia did not indeed pursue a policy of shock therapy — if it had then none of the outcomes which were observed from 1985 to 1998 would have occurred. Aslund dispels the myth that if the Soviet Union pursued a similar approach to China then it would be in the same place by citing the different historical preconditions for reform, the structural differences in both centralized power and composition of their economies:

A fundamental difference between China and the Soviet Union was that China had just gone through the Cultural Revolution, which had terrorized the party bureaucrats, while the Soviet Union had indulged in two decades of Brezhnevism, which accommodated bureaucrats in every regard. In China, the apparatchiks were still on the defensive, which made it possible for Deng Xiaoping to impose reforms from above. In the Soviet Union, by contrast, the bureaucrats were supreme and accepted no undesirable changes.

In April 1985, one month after his accession to power, Gorbachev issued a decree on a minor agricultural reform…

The decree implied some minor decentralization, which would have reduced the power of the Ministry of Agriculture, which thus refused to implement the decree. The agricultural bureaucracy knew it was unbeatable. Wisely, Gorbachev abandoned all attempts to reform agriculture until he reformed the ministry itself, but that did not help because the result was only bureaucratic chaos. In contrast to this overbearing agricultural bureaucracy, in China the initial reforms, which focused on agriculture, could introduce quasi property rights for those who worked the land.

Another Soviet political peculiarity was that the general secretary had very limited power within the Politburo. Gorbachev never managed to achieve a majority in the Politburo for his own cause. After he had defeated the old Brezhnevites, his own appointees, Ligachev and Yeltsin, turned against him from opposing sides. Toward the end, he became a hostage of communist stalwarts. Gorbachev’s strengths were compromise and manipulation, but his weak power, lack of firm principles, and the absence of consensus were disastrous for the consistency of the policy pursued.

It was not true that the Soviet leaders did not experiment. They experimented in the 1920s, 1950s, 1960s, and 1980s, and undertook far more experiments than the Chinese. The Soviet leaders were guided by pragmatism and common sense, exactly as the Chinese advocates of reform, but pragmatism was a major problem for the Soviets. Gradually realizing that much of Marxism-Leninism was bunk, the Soviet leaders were left emptyhanded intellectually. They had no theory and no analytical framework. They were a crowd of the blind, being led by almost equally blind Soviet academicians who had not been allowed to travel abroad or study any of the foreign (capitalist) theories of the last few decades. They were not even permitted to see real Soviet statistics. The early perestroika bears witness to the danger of economic experimentation without any theory.

To the Soviet people, the economic reforms in the 1920s, 1950s, and 1960s were dispiriting experiences. They knew that pioneers would be likely punished some day regardless of what the top politicians said today, so they were understandably reluctant to stick their necks out. Too many heads had been chopped off. Consequently, their response to Gorbachev’s initial reform attempts was muted. The Chinese, by contrast, responded to reforms with an enthusiasm similar to that of the Soviet peoples in the 1920s, and they achieved early impressive results.

The Cultural Revolution had left China in serious economic and social discomfort, which rendered major changes necessary. In the Soviet Union of 1985, by contrast, there was no sense of crisis, but an overwhelming sense of constancy. Most Western analysts thought little would happen for decades (Bergson and Levine 1983). Few but Gorbachev and his allies could imagine that change was possible…

Economically, the structural differences between the Soviet Union and China were large and significant (Sachs and Woo 1994). In the Soviet Union, industry accounted for about half of GDP in 1985, while three quarters of the Chinese worked in agriculture. And the early Gorbachev reforms caused no economic improvements, only aggravated shortages in 1978. Thus, in China, it was possible to omit industry in the early stages of reform, while that was impossible in the Soviet Union. Because Soviet industry was so dominant and powerful, it could be neither circumvented nor simply nudged along. The only viable options were frontal attack or compromises benefiting the captains of industry. Naturally, the old communist establishment preferred the latter option. With its limited state industry, China could bear the resulting costs, whereas in the Soviet Union those costs were overwhelming.

Another structural disparity was that Soviet enterprises were predominantly large-scale and mechanized, while China was dominated by manual labor. Any reform in the Soviet Union had to touch upon large enterprises. Even Soviet agriculture aimed at economies of scale, and a normal collective farm had some 5,000 hectares and matching equipment, because small firms and farms were perceived as backward in the Soviet Union.

While China’s defense expenditures were high by international standards, those of the Soviet Union were outlandish. The Soviet Union had to try to reduce its defense outlays from about one-quarter of GDP to perhaps one-twentieth. This required both arms control agreements with the United States and withdrawal from Afghanistan, two major problems that absorbed much of the leaders’ time. China had no corresponding concerns.

Macroeconomic policy varied greatly between the Soviet Union and China. Gorbachev allowed the previously small budget deficit to rise to 6 percent of GDP in 1986, and it only grew. By ignoring this deficit, Gorbachev guaranteed a future macroeconomic crisis with high inflation. Nobody who was anybody in the Soviet Union had a clue about macroeconomics. Not even the top Soviet academicians knew that a budget deficit could be damaging or that it needed to be financed. “Macroeconomics” was about as negative a word as “capitalism.” Among the many senior officials Gorbachev appointed, none was younger than he, and no nonparty heretics were permitted, and of course no foreigners. China had not fallen as deep into the enforced economic ignorance of communism as the Soviet Union, presumably because its period of communist rule had been much shorter.

Unlike China, the Soviet Union was also hit by a major external shock. In China, the memory of hyperinflation in the 1940s was vivid, and macroeconomic conservativism prevailed. The Soviet Union had benefited from very high international oil prices throughout the 1970s, which had precluded reforms.

In the 1980s, oil prices fell, reaching their lowest level in 1986, when Gorbachev launched perestroika, and they were to stay low for years. Together with the large budget deficit, the low oil prices undermined the Soviet Union’s international finances, which drove the need for more radical reforms (Gaidar 2006). China was less dependent on commodity prices.

In the end, the situations in China and the Soviet Union differed in almost every political and economic regard. The problem was not that Gorbachev did not follow the Chinese lead but rather that he followed it too closely under very different circumstances. Both countries experimented, but the Soviet Union suffered more from the lack of economic theory. The Chinese were sufficiently aware of public finances to avoid any financial crisis, while the Soviet leaders were profoundly ignorant and brought their country to the verge of the abyss of hyperinflation.

In China, central power was sufficient, which was not the case in the Soviet Union. The Chinese experienced a profound sense of crisis after the Cultural Revolution, while the dominant Soviet view after the Brezhnev period was that change was not only wrong but impossible. The Soviet bureaucracy was strong and adamantly opposed to reform, while the Chinese bureaucracy was relatively smaller and softened by the Cultural Revolution.

The Soviet people had seen too many reforms to react positively, whereas the Chinese embraced reform enthusiastically. The large-scale and overindustrialized Soviet Union could not avoid reforming large industrial companies, while those companies were marginal in China and could be omitted from reform. When international oil prices fell, the Soviet Union had little choice but to reform. As a consequence of these preconditions, Soviet communism proved unreformable, while the predicament of Chinese communism goes beyond this study.⁵⁶

Footnotes

[1–4]: Russia’s Capitalist Revolution: Why Market Reform Succeeded and Democracy Failed by Anders Aslund

[5–10]: Russian Economic Reform by James Leitzel

[11–14]: Russia’s Capitalist Revolution: Why Market Reform Succeeded and Democracy Failed by Anders Aslund

[15–21]: Russia’s Capitalist Revolution: Why Market Reform Succeeded and Democracy Failed by Anders Aslund

[22]: Without a Map: Political Tactics and Economic Reform in Russia by Andrei Shleifer

[23]: Russia’s Capitalist Revolution: Why Market Reform Succeeded and Democracy Failed by Anders Aslund

[24–27]: Without a Map: Political Tactics and Economic Reform in Russia by Andrei Shleifer

[28–56]: Russia’s Capitalist Revolution: Why Market Reform Succeeded and Democracy Failed by Anders Aslund