The Myth of Russian Shock Therapy (Part 2)

In the previous installment of this series, I cited Aslund, Leitzel and Shleifer in great detail for the years of Russian economic reform starting from the 1980s to the 1998 Financial Crash.

Jerry Hough who is the author of the Logic of Russian Economic Reform reinforces the argument that Russia during Yeltsin’s tenure was not at all engaged in a policy of “shock therapy”, but quite the opposite.

Hough asserts that it “can be confidently asserted that the Russian economy was centrally regulated and directed from January 1992 through the end of 2000. The central government had overwhelming power vis-a-vis the enterprises, the oligarchs, the banks, and the regions. Neither the neoliberal western economists nor the author of this book approve of the decisions made by the central government, although often for different reasons. However, no one should continue to assert that the Russian government was not strong or that institutions did not exist. In the 1990s the Russian economic system was closer to that of the Soviet Union in 1990 than to a market system.”¹

To support his argument, he exposes the myth that Yeltsin was a passive actor during economic reform and elaborates on how Yeltsin was deeply involved in impacting monetary policy:

The Gaidar team may have wanted to follow a tight money policy in the first months of 1992, as it told westerners, but the Yeltsin government did not — and Yeltsin was both president and premier…

In fact, Yeltsin and the Russian government were deeply involved in all the decisions Aslund mentioned from the first days after independence. By mid-January 1992, Yeltsin spoke of “correctives” to the reform program, including a 50 percent limit on prices, control of prices by monopoly suppliers — and the press said virtually all suppliers had a monopoly position — and social protection for the masses. A month later Yeltsin was deliberately distancing himself from Gaidar in public: Gaidar, the president reported on television, had told the government that the ruble was stabilized, but he, Yeltsin, disagreed and saw very difficult times ahead.

Gaidar was to tell many scholars and reporters that his big mistake had been not to release controls on energy prices in the first months of 1992. In fact, Gaidar never had this option. Yeltsin not only refused to endorse such a measure, but also emphasized his disapproval of the idea by removing Gaidar’s minister of oil, a fellow young economist, in a humiliating manner, as Yeltsin reported with pleasure in his memoirs.

“In May 1992, at a meeting of the Cabinet of Ministers, I announced the dismissal of [Vladimir] Lopukhin [the minister of the oil industry]. I remember two faces: one was scarlet, almost crimson — that was Gaidar; the other was as white as a sheet — that was Lopukhin. . . . There was a very concrete reason for Lopukhin’s dismissal. Using him as a battering ram, Gaidar was putting pressure on me to release prices on energy resources simultaneously with other prices without any restrictions. Future historians will determine which one of us was right, but I will always remember Lopukhin’s deathly pale face.”

During Yeltsin’s tenure, the reform government led by Gaidar announced that they wanted price liberalization and to reduce government spending via subsidies as well as a reduction in industrial employment. They “recognized that the Soviet system had given managers the incentive to hoard labor and that, as a result, the labor force of Soviet factories had been much too large for a long time… the Soviet Union had far too many people employed in agriculture, industry, construction, and transportation; a normal number in areas such as education and health; but far too few in the consumer and financial services. Within industry, far too many were employed in the smokestack and defense industries and too few in the computer and electronics industry. Within transportation, too many were working in railroads and too few in trucking. All branches of the material economy had far too many production workers and too few white-collar staff members.”²

Inherent to the agenda of economic reform was deindustrialization, one would expect that as the industrial workforce shrunk then productivity and wages would go up for those few employed in industry. Industrial production was also expected to drop alongside industrial employment, but the drop in industrial employment never occurred. Hough states that “unemployment rose very slowly despite a precipitous decline in industrial production in the first three years of Yeltsin’s economic reform. While industrial production fell to 75 percent of 1990 levels by 1992, 65 percent by 1993, and 51 percent by 1994, employment in industry itself was 95.6 percent of 1990 levels in 1992, 91.6 percent in 1993, and 82.2 percent in 1994. The wages of skilled workers in heavy industry had always been higher than those of most professional and managerial personnel, and, as table 2–3 shows, this remained true in October 1993. The wages of industrial workers were also generally kept at high levels.”³

So what happened? Why didn’t industrial employment drop alongside a decline in industrial production? Hough explains the Yeltsin administration was engaged in a deliberate policy of social support:

Although many westerners, even at the end of the 1990s, believed that Yeltsin never had a policy of social support, this is not accurate. From the beginning, the Yeltsin government had a very deliberate, sophisticated policy of social support, although almost never articulated, especially to westerners. It was deliberately trying to maintain consumption in the cities in the face of declining production. It was using the factory and other places of employment as its major social welfare institution and was paying wages rather than unemployment insurance to employees even when they were not working. The use of earnings from exports and foreign loans for consumption rather than investment goods had the same purpose, as did the policy of exploiting agriculture to ensure that cities would receive food more cheaply than if prices were market-based.

The former Soviet Union did not have a comprehensive social service system, but used the factory and other places of employment to provide a range of services. Factories built housing with ministerial funds and distributed it to employees through the place of work. They often maintained their workers’ housing in the settlement (poselok) or district and subsidized the police and fire protection for it. The factory built and partially financed clinics, owned and managed farms to provide food for its employees, furnished preschool day care and summer camps for employees’ children, repaired schools and roads, and so forth. Free or cheap vacation passes were provided for resorts owned by the plant or ministry.

If deindustrialization was seriously pursued as a policy which was implied by any adherence to a policy of shock therapy — the idea that the distribution of capital and labor ought to be dictated by market forces as opposed to being sucked in areas of the economy deemed important by the state then it would have destroyed this social infrastructure which had been inherited from the Soviet Union. Hough writes that “the services provided by the factory were highly subsidized, and any manager interested in maximizing profit would try to reduce them as much as possible. In the long run, it was desirable to privatize these services or transfer the subsidized ones to local government, but in the short run, unemployment would have deprived employees of their social support when no replacement was available. The maintenance of employment at the factory, even of people not actually working forty hours a week, was a brilliant administrative solution to the immediate problem.”⁴ More importantly, Hough asks the simple question of “how was the factory to get the money to support a quantity of workers that was excessive in the Soviet period and that became even more excessive as production fell?”⁵

The answer was given in the previous article — direct firm subsidies and cheap credit. Market reformers “talked about the enterprises’ making interenterprise loans to cover their purchases of supplies from one another. But where were the managers obtaining money to pay for wages, social services, and also taxes? The role of government in the economy somehow clearly was far from the role the Russian economic reformers and the government itself acknowledged.”⁶

When the Gaidar Government stated that it would not release price controls on food and medicine — it had to be able to find some way to ensure that these prices were kept down low while also reducing their budget deficit. Hough explains that in order to “cushion the blow on consumers and hospitals, the regime increased the price of medicines sold to them only fourfold… When pharmaceutical plants threatened not to ship medicines for which they were not being paid, the government told the distributors — which were completely state owned — to go to the banks for loans to pay for the medicine. Since the loans to the pharmaceutical distributors were to pay for medicines already sold below cost, the banks knew that the government would pay off the debts through budgetary appropriations, that the loans would never be repaid, or that they would be effectively wiped out by inflation. Either the government was postponing the deficit until later in the year, when it was promising the IMF it would have a lower deficit, or it was engaging in deliberate off-budget deficit financing. Bank officers, who read the press reports of government promises to the IMF, had to know that their loans to the distributors were very high risk, but they still made them. The reason is that they were really state officials, so they did what they were told.”⁷

Hough also goes into detail as to how the Gaidar Government was able to lower the central government’s budget deficit without really getting rid of the subsidies, he did this by offloading the burden to regional governments:

Similarly, Gaidar retained price controls on twelve basic food items, but the controls were administered regionally. However, the regions were not given the necessary money for the subsidies at first. Thus in January 1992 Riazan oblast needed 3 billion rubles for food subsidies, but received only 35 million from the government. It was reported in mid-January that the region asserted it had no choice but to lift all price controls. This problem was quickly solved. Local governments included many of these subsidies in their budgets (although labeled as agricultural subsidies rather than urban ones), along with expenditures for education, health, highly subsidized housing and utilities, and the like, and so they were not part of the budget deficit.

But what was the source of the taxes for these local government budget items? Local government had neither a property tax nor any other significant independent tax… The local governments were not assigned some fixed percentage of the taxes collected by the federal government in their regions and then allowed to raise additional taxes, nor were they forced to cut expenditures in case of tax shortfalls. In official jargon, there were no “fixed norms” on taxes. The regional expenses were decided first, and then the national Ministry of Finance calculated the percentage of taxes that it would assign each region to finance them. The Russian national budget was in deficit, but local budgets remained in balance as the local governments were assigned the percentage of local tax receipts necessary for local expenditures. The frequent allegation that local governments were not “submitting” their taxes to Moscow was simply disinformation: they had no taxes to submit or not to submit.

All of this would have been fine if the large state-owned enterprises had been making a profit. However, they already had excess labor force, and their level of production was falling without a commensurate reduction in the work force. The plants were usually not being paid for the goods they produced and delivered, but they still were paying wages.

They were being assessed a large tax on profits based on the difference between prices of supplies acquired at one time and goods shipped at a later date at inflated prices, but usually without being paid for the goods shipped. Indeed, the head of administration of Yaroslavl hypothesized privately that inflation was tax-push, that it was deliberately created by the government to ensure that a paper profit could be made. The enterprises presumably were getting the money to pay these taxes through loans from the same types of banks that lent to the wholesale pharmaceutical distributors.

A major reason for this practice was that the IMF demanded that the government reduce the budget deficit sharply. Both publicly and privately many in Russia referred to double bookkeeping in which a hidden part of the budget was financed by credit.

Another misconception that was produced by the Gaidar Government was it often said to the public that “central control had disappeared by claiming that plant managers had become a law unto themselves in setting prices and wages and in making loans to one another.”⁸ However, Hough explains that even before Yeltsin, Gorbachev’s reforms in regards to industrial ministries did not really abolish them but they became something else:

The Gorbachev government in the last two years of its existence had initiated a little noticed and still little-understood policy of abolishing the industrial ministries and replacing them with branch “concerns,” “holding companies,” and “corporations” that dealt with the same enterprises as the old ministries. In July 1989 Leonid Abalkin, deputy premier, had told Hedrick Smith that one of the important elements of reform was the “step-by-step elimination of ‘production ministries.’” The first, Gazprom, was created in 1989 from the former Ministry of the Gas Industry and remained a state institution throughout the Gorbachev years. The successors of the ministries created in 1991, however, were formally more privatized.

After the Soviet Union collapsed, all these institutions became instruments of the Russian government. The successors to the ministries were called Roschermet (Russian Ferrous Metallurgy), Rosobshchemash (Russian “General Machinebuilding” or Rockets), and so forth, even though they oversaw Ukrainian plants as well. The result was paradoxical in light of the denunciation of the ministerial nomenklatura: the network of coordinating institutions that had managed and regulated the ministries was destroyed, but the new quasi-ministerial institutions continued to exist and to deal with the non-Russian republics.

Russian reformers seldom mentioned these new institutions, except occasionally as something that old ministerial forces wanted to create. Other westerners thought that they coexisted with the old ministries, or else they were given a very misleading impression about their functions by their Russian sources. The best but extremely brief western discussion of the new entities used the terminology of Soviet informants and called them “trade associations”… The associations did not play an important support role for their enterprises until the last months of 1991, because they were not established before then. In the late 1980s the ministries had often transformed their chief administrative units (glavki) into associations and concerns, probably in order to claim that the size of the ministerial staff was being reduced, but they were quite different institutions. The first ministerial associations, such as Gazprom, were state entities indistinguishable from the old institutions called ministries.

Hough further expands on how deeply connected these “trade associations” were with state enterprise firms and the central government:

In “coordinating input supplies and production,” they were maintaining the old supply ties in the same basic way that the ministries and the central planning organs had always done. In “providing investment and financial assistance,” they, alas, provided no investment assistance at all, but instead were the main conduit for state subsidies for wages and taxes and the main organizers of “interenterprise loans.”

In fact, the holding companies and corporations, together with the branch commercial banks, were brought under the effective, if unacknowledged, control of the Ministry of Industry and its departments and then of more specialized ministries when they were formed. The nature of their relationship is clear from their location. The Tractor and Agricultural Machinery Department and the Automobile Department of the Ministry of Industry were both located in the old building of the Ministry of the Automobile Industry and the Ministry of Tractor and Agricultural Machinery Industry. The heads of the two departments occupied adjacent offices — the offices of the respective former ministers.

On the same floor, less than 100 yards away, was the office of the head of the industry’s holding company, Avtoselkhozmashkholding. In October 1992 the sign on the wall gave the name of the head of the holding company: Nikolai A. Pugin, the USSR minister of the automobile industry from 1986 to 1991. The head of the Tractor and Agricultural Machinery Department of the Ministry of Industry said in an interview that the holding company was independent of the ministry, but a cynic might wonder about the independence of a holding company headed by a former USSR minister located on the same floor as the department.

Contrary to the claim that the inflation during Yeltsin’s tenure came out of nowhere and was not within the control of the Reform Government, Hough states how the Gaidar Government claimed that state enterprises operated autonomously “but the holding companies closely associated with the industrial ministries were organizing the procurement and delivery of all their supplies. Thus the holding companies had to be deeply involved not only in the organization of interenterprise loans, but also in setting the prices of supplies, which presumably had to include their own commissions. The branch banks making the loans that the plants needed for wages were also closely associated with the industrial ministries. It thus makes no sense whatsoever to say that enterprise managers autonomously set prices and wages, causing virtually uncontrolled inflation.”⁹

Hough explains how Yeltsin’s tenure did not remove government control from the economy, but rather simply made the individual subunits private as in while the assembly plants may be private — the overarching owner was still the government and so Hough demonstrates this below:

[T]he Yeltsin government did begin seriously to attack the power of the holding companies in the summer of 1992. Most of the large enterprises were turned into stock companies and became, in reality, the property of their management. The top managers in the holding companies saw that they had to be at the enterprise level to acquire riches…

This “nomenklatura privatization” at the enterprise level was severely criticized by the radical reformers, but, in fact, the alternative at the time was the strengthening of the ministry-like holding companies. In March 1992 the head of Pharmindustriia told me that he was giving a great deal of thought to acquiring shares in his plants and maintaining control of them as they were privatized. The income from the “wholesale trade” was meant to be the source of capital if the concerns were to turn into large corporations and acquire their production plants, but the holding companies were accumulating debt from the enterprises and hoped to transform it into equity as well.

Such a pattern might have been desirable from an economic point of view. Soviet enterprises were comparable to western assembly plants rather than to large western corporations. The continued domination of the holding companies and their transformation into giant corporations that owned their production or assembly plants would have been one of the better ways for Soviet economic reform to evolve. Once these companies became the equivalent of the original Standard Oil of New Jersey, government control could have been loosened and an antimonopoly policy could have divided them into competing mini-ministries (companies), such as were created from Standard Oil and are the dominant units in the modern western economy. Then they could have become more genuinely privatized…

However, the radical Russian reformers were not thinking in terms of the nature of the modern western economy and the role of giant corporations and their production plants within it. They were planning to privatize assembly plants…

The evolution of the holding companies after 1992 remains obscure. Many, if not most, continued to exist, and the press reports suggested that they did become more like trade associations over time. However, Roslespom (Russia Timber Industry) remained a state company that controlled the timber industry, and Rosugol (Russian Coal) had a similar role in the coal industry. A new Rostekstil was formed in 1993 “on the basis of the Ministry of Textiles,” and almost all the private plants became part of it to receive orders, financing, and subsidies. Since textile production fell ten times between 1991 and 1997, Rostekstil was mainly providing subsidies. A 1998 article, for example, discussed how the governor of Vladimir persuaded Rostekstil to give more orders and raw materials to Vladimir textile plants.

Furthermore, Hough goes into detail as to how the government was able to control “private” banks directly through a similar relationship as with industrial state enterprises:

The crucial instruments in off-budget financing were the “privatized” commercial banks or, at least, the type of “privatized” commercial bank that became dominant in Russia… The leading economic reformer from 1988 to 1990, Leonid Abalkin, was much attracted to the Japanese economic model, and he and the central government tried to create a banking system that brought the banks into close association with the top industrial organizations. In 1987, as a first step in this direction, the USSR Gosbank was split. Five specialized banks were created, corresponding with the major sectors of the economy and the deputy premiers who supervised them.

In 1988 and 1989 these specialized banks were supplemented by an increasing number of “commercial banks,” and then the specialized banks and their subdivisions themselves became “commercial” banks. Some of the commercial banks were small and served the new cooperative enterprises that were beginning to be created. It was rumored — surely with frequent accuracy — that they often were “mafia banks” that laundered money from various types of illegal activities in the West. Some of them also accepted deposits from customers, but paid interest at rates so high they obviously were — and proved to be — pyramid schemes.

The major commercial banks created in 1989 were branch banks that were closely tied with the ministries and large enterprises. The largest and best publicized was Avtobank. In early 1990 the new Bank for the Development of the Automobile Industry of the USSR (Avtobank) was described both as a stock society whose stockholders were almost all automobile and agricultural machinery enterprises and as “a component part of the state apparatus.” The branch banks were to perform the short-term banking functions for the enterprises and pay them interest on their money, but they were also to provide long-term investment to both their own plants and their suppliers. The manager of the bank was the head of the finance department of the Ministry of the Automobile Industry, and the bank was located in the building of the Ministry of the Automobile Industry — presumably the same building where Avtoselkhozmashkholding was located.

The role of these branch commercial banks could be seen through several prisms. Since reform was somewhat chaotic, many in the banking system showed considerable independence during the period, but this independence took place within limits. The primary function of the commercial banks was to serve as the conduit of funds between the government and the plants, and they remained basically under the control of the ministry or plant that founded them. The branch banks were meant to give the ministries and their plants more financial flexibility in an era when supply procurement was becoming more decentralized and interenterprise payments more unreliable.

As long as the industrial institutions were fundamentally solvent, the branch commercial banks played a useful role as inside banks of the industrialists. They gave the enterprises the opportunity to earn interest on their funds and to obtain quick loans at a time of economic instability. They were an intelligent transition step on the road to more independent banks or at least to German- and Japanese-type banks. That surely is how Abalkin saw them…

The banks were closely tied with the new holding companies and the departments of an industrial ministry. For example Stankinbank, the machine tool and instrument “commercial” bank that served the industry once administered by the USSR Ministry of Machine Tools and Instruments, was physically located in the same building off Pushkin Square as the Department of the Machine Tool and Instrument Industry of the Russian Ministry of Industry. Top IMF officials working with the Russians could not distinguish between bank and government because there was no distinction…

The Central Bank and its chairman, Viktor Gerashchenko, were often used as a scapegoat in the West because of the credits and excess money, but, in fact, the direct credits the bank provided for the branches and their commercial banks reflected government policy. The branch commercial banks themselves did not make loans to enterprises independently, but responded to instructions from the Ministry of Finance and the Ministry of the Economy (the new name for Gosplan or the State Planning Committee, which retained a staff of some 2,000 persons) and from the holding companies. The result was, in the words of a Moscow professor, “a quasi-budget system of specialized banks that have little in common with market principles of distribution of credit resources.”

Michael Bernstam and Alvin Rabushka summarized the situation well: “Commercial banks in Russia were not, and still are not, normal banks as found in market economies. They do not accept deposits paying a market rate of interest or make loans on the basis of commercial criteria. They do not fulfill the normal role of intermediating household deposits to enterprises, thereby converting savings into investment. Instead, Russian banks have served primarily as government agencies that redistribute public funds to enterprises, mostly to favored ones, or as profit centers trading in foreign exchange, government bonds, or insider lending. The banks may look and feel as though they are private enterprises, especially to outsiders, but in fact they have largely served the government’s discretionary allocation of subsidies to other enterprises and also financed political causes.”

However, just because they were under the direct influence of the government does not mean that these commercial banks were not engaged in rent-seeking — Hough states how “the increasingly chaotic administrative system and the ‘war of laws’ between the USSR government and the republics allowed the semi-independent banks to finance various types of semilegal trading, currency speculation, and the like. This meant that the branch banks could also serve the personal interests of those working in the banks and the ministry. At a minimum, the banks paid dividends to their shareholders, and at some point these shareholders came to include individuals as well as institutions.”¹⁰

The direct subsidies provided by the Central Bank in the first year [1992] ultimately, of course, came from the government’s export earnings. As the government had to change this system of direct subsidies and replace it with “loans” from “private” banks, it had to find methods of getting funds to these banks for them to lend. The deeper one probes, the more imaginative are the devices one discovers as the regime sought methods that would at least temporarily survive the scrutiny of the IMF. Many of the actions that were explained to the West as personal corruption actually were covert means of financing the off-budget loans.

Increasingly the foreign trade banks were allowed to retain more of the earnings so that they could make the subsidies themselves. The important foreign trade banks all were “authorized” (upolnomochennye) banks that served one or another purpose for the government and were paid for their services. The heads of these banks were called oligarchs by the press, but the banks were government creatures and, to all intents and purposes, government banks. In practice, the banks usually were each the patrimony of the key figures in the Yeltsin government and their institutions, and the top bankers were their bagmen rather than oligarchs. When top officials fell, their bagmen and their banks tended also to disappear.

Oneximbank was, for example, not created until 1993, and it was headed by a seemingly obscure foreign trade official, Vladimir Potanin. It quickly became one of the most important banks because it was given responsibility for all money from all customs payments. Potanin proposed, and the Ministry of Finance agreed, that importers pay their customs before the goods arrived so there would be no delays. It was suggested that importers keep a sum deposited in Oneximbank for this purpose. In the interim, Oneximbank was able to use this money to serve government functions or to benefit itself.

The Reality of Russian Privatization

Without any question, a great deal of privatization took place in the Soviet Union after 1990, at least formally, but it is unclear what this meant. The Russian economic system fits none of the usual categories of analysis. Much of what was called “state property” was subject to personalized control. Much of what is considered privatized property had little relationship to normal concepts of private property. The “owners” of a major hard-currency producer, Norilsk Nickel, were not allowed to retain enough of its profits to make capital repairs at its copper plant for fifteen years, let alone capital improvements.

Tatneft (Tatarstan Oil) had to “barter” its oil to major petrochemical firms in the republic at belowmarket prices and even then often did not receive payment at the artificially low price and could not pay its workers for three months. This was an enterprise audited by Price Waterhouse and listed on the New York Stock Exchange. Gazprom not only had to send its gas free to many customers, but it had to loan $650 million to Cheliabinsk Tractor Works to pay off its debts even though it would not be able to produce a significant number of tractors in the foreseeable future. Many profitable banks and plants were forced to buy unprofitable ones.

There is a real question how much these large enterprises are privatized and how much they really are still controlled by the state. Their managers or owners were, of course, much freer to misappropriate funds than in well-organized nationalized enterprises. Yet the owners of important pieces of economic property did not have nearly as much independence in decisionmaking as comparable property owners in the West, and the term barter often hid the obligation to fulfill direct state orders. Their “lack of defined property rights” went well beyond the usual meaning of those words. Indeed, the owners often were as susceptible to government removal from the “ownership” of their property as if they were government bureaucrats. The off-budget subsidies meant that all plants were bankrupt and that this could be made formal at any time.

Private property is always a conditional concept. There are a myriad of restrictions on the way that property can be used and sold in the West — restrictions that are embedded in zoning, access, anti-fraud, labor, safety, environmental, and other regulatory laws. Indeed, there are so many restrictions that one can visualize private property in the West as being state-owned and leased to people for their restricted right to use and dispose of in exchange for the payment of a rent called taxes.

In the western conception of private property, however, the various government restrictions on the use of property are relatively impersonal and predictable. They obviously can be modified over time, but the process of change is usually gradual enough to allow owners to adjust or sell. Entrepreneurs, we say, are subject to the law. Although the law is state-made and state-enforced, our language implies that the restrictions are universal, not the product of the discretion of individual state officials. The owners at least own the right to sell their lease. We take for granted that taxes will not be confiscatory and that the restrictions will allow businesses to function and make a profit.

Those who headed the privatization program in Russia claimed that it involved depoliticization. Andrei Shleifer and Maxim Boycko distinguished between managers and politicians in the Soviet Union, and they described the former as largely concerned with value maximization and the latter primarily as the agents of rent-seeking interest groups. They argued against nomenklatura privatization on the ground that “politicians are good at designing subsidy programs, not business plans.”

Nothing could be more misleading. It made no sense to distinguish between politicians and managers in the Soviet system. As Zbigniew Brzezinski emphasized at the beginning of the Brezhnev period, the political posts in the Soviet system were occupied by those who had arisen through a bureaucratic, managerial hierarchy. Boris Yeltsin was the typical politician. He worked for eleven years as a successful construction manager before spending nine years in party work dealing with construction. Then he became the equivalent of a state governor. Viktor Chernomyrdin moved back and forth between party and managerial work before becoming minister of the gas industry.

The Soviet economic system was not really politicized in this sense of the word, but instead was thoroughly bureaucratized. Young scholars in both Russia and the United States often look back at the Soviet Union as if the catch phrase “command economy” actually reflected the reality of the Soviet economic system. No idea is more bizarre to a scholar who studied that system in detail for thirty years. The Soviet economic system was bureaucratic; it lacked competition between producers; and its incentive system encouraged managers to make compromises with quality and with innovation. But it was a system in which the planning process began from below as it does in any bureaucracy. Soviet leaders and economists gave inordinate attention to the creation of incentives and indicators to try to lead managers to optimal decisions and to reward them if they fulfilled the goals set in the indicators. As a result, the economic system had relatively little arbitrary intervention by politicians in the Brezhnev era, but it had the opposite flaw. It was too regularized and too inflexible for a complex modern economy…

The incentive system led the managers to behavior that the founders of the incentive system wanted: the maximization of production, even at some cost to quality and efficiency; an emphasis on the expansion of smokestack industry rather than consumers’ goods, especially luxury consumer goods; the end of unemployment; and a far more egalitarian distribution of income than in capitalism, especially early capitalism…

The first requirement of economic reform was the introduction of competition into the system and greater flexibility into production and investment decisionmaking. Everyone agreed that this meant a fundamental change in the incentive system for economic actors. The problem for the state was to replace a regularized bureaucratic economic system with one in which the enterprises responded to more impersonal contractual rules and incentives and in which conditions were created for easy entry by newcomers.

In actuality, Yeltsin created a classic politicized economy. An orderly bureaucratized economy was replaced by one ruled through personalistic, patrimonial bureaucracies by top officials without job security who were preoccupied with palace politics and the acquisition of property. Those with successful economic enterprises had no property right in their output, but were forced to give subsidies to others. Those in economic difficulties had to receive subsidies awarded not by some impersonal formula, but through personal favor. The subsidies were made in forms that made them bankrupt. Hence they had no secure property rights of any kind. The line between personal and official was obliterated, and everyone was motivated to concentrate on promoting short term personal interests and seeking political favor…

The ugly truth about the Russian privatization program — and it is far uglier than the well-known scandals — is that the neoliberal Russian economic reformers knew that they did not have the managerial skills to be the most efficient owners — that they would lose in the competition... Hence it was even more necessary for them to engage in grabification than the insiders of the Gorbachev era. The West supported them fully in this effort by opposing transparent subsidy grants and by making bankruptcy of old owners a high priority through a series of mechanisms.

Stanley Fischer, the future first deputy director of the IMF, showed at the Brookings conference in 1993 that he grasped this point when he implied that Yeltsin and those in his government were politicians and driven to rent-seeking like other politicians…

Fischer and other westerners should have understood that the crucial difference between the nomenklatura and the politicians in the reform team was that the latter were not limited to traditional types of rent seeking. The logic of collective action correctly indicated that they had an interest in shaping the fundamental institutions and incentives of the economic system to serve not the collective interests, but their own. They had the ability to do so. Instead, Fischer called for removal of the nomenklatura and their replacement by technically qualified personnel, which is precisely what the old nomenklatura were…

The issue to which the West should have been giving far more attention was the incentives that were being created for the owners of the newly privatized property. The West understood from the experience of eastern Germany that an enormous amount of capital investment was needed to modernize a communist country even of that size. Russia had eight times the population of eastern Germany and did not have a western Germany to support it. The top priority was to create the right incentive structure for massive domestic and foreign investment. Instead, an incentive system was established that made capital investment and capital repair virtually impossible.

Much like how Leitzel stated in the previous article about uncertain property rights, Hough explains that in “a market that is just being created, the trust needed for long-term investment often arises from personal ties of friendship (this is frequently the basis for corruption) or, perhaps, kinship or ethnicity. Trust in impersonal financial institutions and unknown people rests on the development of confidence in the formal rules, the laws, and the incentive system and on the mechanisms that enforce them. The development of such institutions and especially confidence in them should have been the first task in Russia in 1990, but little effort was devoted to it. Hence it was totally rational for individuals to take an extremely short-term position or, if they could, to send their savings to a safer institutional environment abroad.”¹¹

Hough states that the “problem in Russia in the 1990s was not that the government was weak in the sense of being uninvolved in the economic sphere. The government was directing actions of regions, banks, and enterprises in a very detailed manner. The problem was that it was establishing incentives and taking concrete actions that undercut investment instead of supporting it.”¹²

[T]he enormous concern about the extent of high-level corruption in Russia in the 1990s is quite misplaced. Given the absence of a functioning banking system, government as an institution and government officials as individuals inevitably had to be key players in the investment process. The real issue was not the corruption, but what the corrupt did with their money. Any defense of corruption assumes that the money will be invested at home. There is every reason for this to occur if the economic incentive system is working properly. An investor with inside knowledge and government protection should receive far higher returns by investing in an emerging market than in a Swiss bank account or even western mutual funds.

The clearest sign that the Russian incentive system was not functioning properly was not that corruption occurred, but that the corrupt did not find it profitable to invest at home. This was true even in the mid 1990s, when westerners saw Russia as a highly profitable emerging market. Corruption should have facilitated investment, but those with inside knowledge saw that capital flight was the most profitable use of their money. The factors in the incentive system that led the corrupt not to invest were the same that influenced potential honest investors. They should have influenced western investors…

The problem was not that government and institutions were absent, but that they created incentives that were counterproductive for economic growth and the collective good. The incentives established by the state did not lead individuals to take a long-term perspective about investment. Instead, economic actors were placed in a game in which the only intelligent strategy was usually to grab.

To demonstrate this incentive to not invest and save, Hough explains how the Gaidar Government in regards to agriculture produced significant restrictions on the ability of both state and private actors to accumulate capital which is the thing that allows for investment:

Gorbachev’s first great mistake in economic reform was his failure to introduce any significant type of agricultural reform. The reason was that agricultural reform could not be successful unless anomalies in retail food prices were reduced. Bread in the stores cost less than the peasants were paid for the grain to produce it, and meat was sold in state stores at one-third the price paid to peasants to produce it. Regions were paid different amounts for grain; those with poor land and climate were paid much more than those with good land and climate. Unless these situations were corrected, any marketization of agriculture would have counterproductive results.

Over the years western advocates of decollectivization emphasized the positive effects of individual ownership or control of land on production decisions, but the more knowledgeable understood that agricultural reform would have equally crucial effects on investment decisions. The policy of differential regional prices was designed to equalize conditions for peasants living in different areas, and it had been accompanied by a partial attempt to equalize investment. This was as if too much agricultural investment was directed to areas like northern Maine and too little to areas like Iowa and Illinois.

One purpose of agricultural reform was to ensure that decisionmakers — collective farm managers, if not individual farmers or heads of smaller groups — could acquire the machinery and other equipment they considered most appropriate for their land. In a market economy, those in the most fertile areas in the best climate zones would receive the greatest income, and they would thus have the most money to invest. If investment were concentrated in Iowa instead of being split between Iowa and Maine, the results surely would be much better.

Instead, the Yeltsin government had an unannounced but explicit policy of trying to maintain living standards in the largest cities at the expense of the countryside. The old USSR Ministry of Procurements (sometimes called the Ministry of Grain Products) was retained as Roskhleboprodukt, and wholesale agricultural trade was kept under full state control. Much of the trade was conducted by nonmonetary means, heavily discriminating against the agricultural sector. The Yeltsin regime gave some subsidy to unprofitable northern farms, but did not introduce market prices for the fertile farms in the south…

The reformers blamed the steady decline in agricultural production on the defects and corruption of the collective farm nomenklatura rather than on the decline in inputs and investment. They pushed the free sale of land as a panacea, but, in fact, the private farm sector failed as badly as the collective farm sector. Prices were just too low for private farmers to survive economically.

The result of policy was dramatically seen in the pattern of regional politics. In the 1890s, the grain-exporting areas of the south had supported free trade, while the north had supported protectionism, a pattern that economic theory would predict. In the 1990s, contrary to the normal logic of foreign economic politics, the fertile rural south was the stronghold of communist support, the so-called Red Belt. Many in the poor farms in the north clung to Yeltsin as the only source of protection against the market. The explanation was not cultural conservatism in the south, but the southern farmers’ response to a lack of reform and to a policy that had exploited them to feed the cities, much as Stalin had done in 1929.

Investment in agriculture did not occur because government consciously left the economic actors with too little money to invest. The prices for products required by agriculture (first of all, fuel) rose five times faster than those of agricultural products. The result was a decline in capital investment in the agroindustrial complex in constant rubles from 60 billion (51 billion of which was for agriculture alone) in 1990 to 11 billion (8 billion for agriculture) in 1993 to 8 billion (6 billion) in 1994 and an estimated 6 billion (4 billion) in 1995. Agriculture received 16,000 tractors in 1994 out of 26,700 produced, compared with 143,700 in 1990.27 Each hectare in agriculture received an average of 99 kilograms of mineral fertilizer in the 1986–90 period, but this fell to 78 in 1991, 43 in 1992, 29 in 1993, and 11 in 1994.

Moreover, Hough states that the overemphasis on privatizing existing large companies left a huge gap in that no new small business sector could develop in the absence of any sort of institutional framework especially when property rights were so poorly defined and protected:

In October 1991 Yeltsin foresaw the immediate rise of small companies to provide competition for the large corporations with monopoly products and components, but this did not occur. The statistics on the number of small businesses are not accurate, but everyone agrees that far too few have been created, especially industrial businesses or businesses serving industry.

The first reason that the new business sector did not thrive is that it was never a priority of the reformers and government. Unlike China, Russia devoted all its attention to the privatization of existing state enterprises. The government did not focus on creating rules and tax incentives that would encourage small businesses and investment in them. It did not allow the formation of major banks that could make loans to them. As a result, entrepreneurs could more easily maximize profit by trying to acquire an already functioning business in the privatization process than by creating a new one.

In many ways, what Hough describes above could explain the motivation for cronyism and rent-seeking especially through the privatization process — individuals had no way of starting new firms because they lacked protection and economic power to maintain their claim. The only rational thing to do was to seize existing firms and solidify one’s control from there.

The question is, why did this money not flow into small-scale business investment of various types? The standard answer was the absence of a reliable legal system, the presence of too much corruption, and the existence of a mafia. Someone who tried to establish a new business had to pay bribes to numerous local officials and police officers. They likely would be visited by those who offered protection for a price and threatened with violence if they did not purchase the protection they offered…

It is likely, however, that the West exaggerates the importance of crime in constraining the small business sector…

The real obstacles to the development of a thriving small business sector lay elsewhere. First, a banking system was not established to provide reliable loans to small business at reasonable rates. Originally a number of private banks offered extremely high interest rates to depositors, but they were essentially pyramid schemes. Their collapse and the increase in the interest rates in the state savings banks led citizens to deposit almost all their savings in local branches of the large Moscow banks, most notably Sberbank, the Savings Bank. Sberbank placed its funds at the disposal of the central government instead of lending them locally. As a result, no institutions existed to serve as intermediaries between local savers and business.

Second, the lack of stability in local property rights and the absence of a stable local tax base made the local political elite less interested in controlling local corruption. If local officials had a clear stake in the local community and its long-term prosperity, they would have an interest in promoting prosperity. If they obtained money by legal or illegal means, they would be likely to invest it in the local economy. If criminals began seriously to harm the interests of the local elite, the elite would strive to control or coopt the criminals. In the United States, mafia-like institutions are, after all, quite transitory phenomena that tend to disappear when they no longer serve economic functions.

Lastly, Hough finishes off his argument by stating that the Gaidar Government’s emphasis on consumption and financing it through credit as well as depleting state firms and banks of their savings — established an environment that essentially forced private actors to find ways to strip assets from newly privatized firms, and pursue short-term interest:

In discussing the system of off-budget subsidies of the Yeltsin period, this book has focused on those who received the subsidies and the personalistic mechanisms by which they were provided. It has emphasized that they were consumption subsidies, financed by an exploitation of agriculture and a sharp reduction in investment. But, of course, subsidies had to come from specific industrial exporters, banks, and trading firms, and this had a powerful effect on the incentives of the latter.

A cliche in the western history of the Soviet Union was that Lenin made a terrible mistake during the period of war communism (1918–20) in the Civil War by having the Red Army simply requisition grain that it found in the countryside. The result, everyone said, was that the peasants had no incentive to produce. But Lenin recognized this in late 1920 and introduced a tax-in-kind in agriculture. The peasants were assigned a fixed amount of produce to deliver and were allowed to keep whatever production remained after the deliveries were made. When Stalin abolished private agriculture and trade in 1929, he retained the principle of trying to build incentives into the economic system. In a famous 1931 speech, he denounced the practice of “leveling” — of too much egalitarianism

In essence Yeltsin returned to the system of taxation that the Soviet Union had during the period of war communism, and the system became even more confiscatory as the economic situation became more desperate with the passage of time. If a region decided to introduce some new tax, this would simply have resulted in its receiving fewer loans or less free natural gas and electricity. If an export firm or any other firm generated more profits, it was certain to be required to deliver (“barter”) more goods without payment or to purchase an unprofitable factory or make a loan to someone.

It is difficult to imagine another economic system that would have created such powerful incentives for managers not to focus on economic growth or investment. It is difficult to imagine another economic system that would have created such a powerful incentive for the honest and the corrupt alike to send their savings abroad rather than invest at home.

In fact, the system must have given many participants a sense of moral rectitude in corruption. Viktor Chernomyrdin and the oligarchs associated with him in the energy industries have often been criticized in Russia and the West for their corruption. It is, however, difficult not to have some sympathy for them. They had spent their lives in building the Soviet oil and natural gas industry and had every right to be proud of their achievement. Now production had fallen nearly in half because the government refused to allow them to develop new fields or even maintain the old ones.

If Gazprom worked to improve production and sales, it simply would be asked for another $650,000 loan for another plant like the Cheliabinsk Tractor Plant, a plant whose managers were probably largely corrupt. If the government was going to steal from the industry Gazprom’s managers had developed, they must have felt a moral right to do so themselves. If they had money abroad, they might have rationalized to themselves it would be available later to invest in Gazprom when an intelligent economic policy was introduced some time in the future.