Re-establish the Russian state

Russia today proves the point that economic reform cannot take place in the absence of governance.

When governance collapses, no mount of foreign money can save a failed state like Russia. Quick-fixes like those attempted by the IMF will fail or work only temporarily. The fundamental problem is not economic policy but governance, which is moribund. To re-establish the Russian economy, you must first re-establish the Russian state.

Many bogus theories have been floated for years to explain Russia’s economic mess. The left ascribes it to over-rapid liberalisation, the right to insufficient liberalisation. Both fail to realise the key importance of good governance.

Of the ex-communist countries, the fastest reformers (Poland and Hungary, the Baltic states) have fared best. Poland, the front-runner today with 6.5 per cent GDP growth, went for early, massive structural adjustment with its Big Bang, which caused much initial pain but now provides the most dynamism. Slovenia, which liberalised very fast, is today the richest ex-communist country (its GDP per head exceeds $10,000).

By contrast the slowest liberalisers in the region, Belarus and Ukraine, are in the deepest trouble. So nobody should ascribe Russia’s problems to over-fast reform. Had it gone slower, it would have ended up closer to Ukraine than Poland in performance.

Gradualism has worked in China, but only because of continued Communist autocracy. The political revolution in the Soviet empire made Chinese style gradualism impossible. Besides, 80 per cent of China’s population was rural when Deng’s reforms began, against 25 per cent in Russia. So Deng’s first reforms, giving peasants property rights over their output and farms, produced an explosion of well-distributed growth that could never be replicated in urbanised communist Europe.

The Soviet empire began unravelling in 1989. First, eastern Europe threw off the communist yoke. This led to the collapse of Comecon, the trading-and-payments system that underpinned the whole Soviet empire. This disruption of trade and payments reduced GDP in the Comecon by a whopping 20 per cent.

Then the Soviet Union broke up in chaos into over a dozen countries.

Russia ran into immediate problems of governance because of the collapse of revenue. The provinces stopped sending revenue to Moscow. When the state could not pay its apparatchiks, they quickly evolved into the new mafia. A veneer of markets was created, but the underlying reality was mafia commandism. The mafia is anti-market: it kills the competition, literally. This is poorly understood by simplistic right-wingers in the West who think Russia’s main problem is that it has not liberalised enough.

Capitalism works only if markets and competition exist. Neither did when the Soviet Union collapsed. In Eastern Europe, market institutions were built, imperfectly and with many gaps, over several years. They made much less progress in Russia because real reform was consistently undermined by the new mafia-cum-apparatchiks-cum-politicians.

Yeltsin managed to avoid economic collapse this long only because of billions of dollars were poured into Russia for foreign policy reasons. Russia still bristles with nuclear weapons, and the West trusts Yeltsin far more than the others to handle these weapons sensibly. Hence the West has propped up Yeltsin with money. In the old days, this money would have come as grants from the US — and the dollar inflow could have been sustained on that basis. But the US Congress today is tight-fisted, and so the money has come as loans from the European Bank for Reconstruction and Development, the World Bank and IMF.

But loans, unlike grants, have to be repaid. And since the dollars borrowed are not being used productively, Russia has never been far from a payments crisis.

In the Russian presidential election two years ago, Yeltsin faced a significant challenge from Zyuganov. I argued at the time that Zyuganov would be a better choice, because he would combat the mafia-apparatchiks whereas Yeltsin would continue protecting them. However, the IMF promised vast sums to prop up Yeltsin, and this turned the balance in his favour.

IMF money was conditional on wide-ranging reforms, but Yeltsin knew the cash was basically political, and ignored many conditions. He has done little to clean up the banking system or fiscal deficit. More than 100 bankers were killed in the early Yeltsin years as the mafia shot anyone who opposed them in the financial sector. But even this problem pales in comparison with the collapse of revenue, which has exacerbated the fiscal deficit.

Revenue is the very foundation of the state. Indeed, the state is defined as the only authority that can levy taxes and collect revenue. If the state becomes so moribund that it cannot collect its dues (while the mafia imposes and collects levies with impunity), governance collapses. When that happens, the state has to be reestablished.

In communist times, public sector surpluses generated most revenue for the state. But today there are no public sector surpluses. A communist state allocates money by fiat. When a country shifts to a market system, millions of households deposit their savings in the financial system (banks, insurance companies, capital markets), which then allocate this to investors. This is marketisation, but in Russia this allocation function has been aborted by mafia takeover. Privatisation in these circumstances has meant handing over state assets to mafia-apparatchiks. No wonder the biggest corporations like Lukoil and Gazprom (the oil and gas giants) simply do not pay their huge tax dues: they get political protection from the top.

Naturally, this has created a revenue crisis. Yeltsin has tried to cut the fiscal deficit by not paying workers (wage arrears are an astonishing 78 billion rubles), and by borrowing from the IMF and commercial lenders. One third of the government’s treasury bills are held by foreigners. But borrowing becomes unsustainable as the debt and interest payments mount. The IMF favoured a fixed exchange rate to lend credibility to inflation-reduction. But capital flight plus a lack of revenue meant that interest rates skyrocketed to over 100 per cent. Yeltsin ultimately devalued, after having wasted $4.8 billion of IMF money in trying to prop up the ruble.

Western governments hoped that IMF money would perpetuate the illusion of solvency. But the markets were not impressed, and the ruble collapsed despite the IMF rescue package of $22 billion.

Some short-term fixes may now be engineered. But the underlying problem cannot be solved without restoring good governance. In a market system, many banks would close. Their depositors would be protected but their owners would go bust. But in Russia the banks are owned by Yeltsin’s pals, so he has decided to rescue them. He cannot pay the wages of government employees, yet proposes to spend billions on rescuing crooked millionaires.

More IMF money to Russia in such circumstances will be money down the drain. The sad consequence of loans to the Russian kleptocracy has been to line the pockets of the kleptocracy while saddling the country with unpayable debts. More loans may prop up Yeltsin temporarily. But they will delay the reform of governance.

I have no easy solution to prescribe. All I can say is that Russia needs a new government tough enough to take on the apparatchiks and combat mafia commandism. The prospects are not bright.

What do you think?