When property is theft.

Why Russia's market reform failed - and what to do about it.

Russia's economic collapse in August came as a shock to many in the West. Just a few months before, the reform process - involving billions of International Monetary Fund dollars and countless hours of Harvard consultants' time - seemed to be going well: The bulk of state industry inherited from the Soviet Union had been privatized; inflation had been conquered; the ruble had been stabilized. Any visitor to Moscow could see signs of prosperity: a new superhighway circling the city, construction cranes everywhere, streets crowded with cars and lined with glitzy shops. Certainly there was much more to be done, but reform was widely declared to have reached the gratifying point of irreversibility.

By September, all of this had changed. Russia clearly had stumbled on the road to the market. Without the rule of law or secure property rights, privatization had failed to spur investment and growth. Without a functional banking system or a public sector willing to live within its means, monetary austerity alone could not achieve lasting financial stability. And without a respect for social justice based on the right of ordinary people to benefit from the fruits of their own labor, democracy and market reforms became terms of derision everywhere outside Moscow's glittering bubble economy.

For some, the Russian debacle shows that a market economy is not such a good idea after all, at least for Russia. David Johnson, whose electronic newsletter, Johnson's Russia List, is the bible of serious Russia watchers, has gone so far as to suggest that the West should apologize for its advice on market reform. The truth is more complex. The lesson to be drawn from Russia is not that markets themselves are a bad idea but, rather, that it is a bad idea to quickly throw up a market facade before laying a firm foundation. Let's take a look at just how the present sad situation came about.

Privatization without Property Rights

Although Russian President Boris Yeltsin and his team did not get everything right, they at least understood that a market must be based on private property. That was progress compared with Soviet President Mikhail Gorbachev's perestroika. The latter was a lineal descendant of the Lange-Lerner socialist market model of the 1930s, under which owners of state firms were supposed to imitate market behavior in response to artificial price signals from a central authority - an idea Ludwig von Mises aptly described as adults playing at markets the way children play at trains. The Yeltsin reforms, by contrast, were to feature the actual transfer of state property into private hands.

That left open the question of who the new owners should be. There was a widely held view that, as far as economics went, state property could be sold or even given away to just about anyone: workers, former Communist Party officials, the Red Directors who actually ran the factories, or even foreign investors. Whatever the details, it was reasoned, the new owners would have an incentive to maximize the value of their property. If they couldn't run it competently, they would best enrich themselves by hiring professional managers or selling to better qualified investors. While some privatized firms would go under, new start-ups would emerge, absorbing workers and resources released by the failures.

But while the question of ownership seemed of secondary importance economically, it was seen as crucial politically. Key Western advisers like Harvard's Andrei Shleifer argued that privatization would never take place unless those who could block it politically were, in effect, bribed with a share of the spoils.

There was a certain amount of good sense in this view, which was grounded, in part, on Margaret Thatcher's successful efforts to spread the fruits of British privatization widely enough to ensure political support. But what music Shleifer's version of the Thatcher doctrine was to the ears of the Communist Party apparatchiks and komsomol (Communist Youth League) whiz kids who were in a position to make things happen! With the blessing of Western advisers, they helped themselves to whatever choice morsels of state property were closest to hand. Workers at most plants were given large enough blocks of stock to keep them quiet, but with restrictions on the right to sell and other devices that limited their effective control. Small shops were typically privatized by the people who worked in them.

In a massive public relations effort, millions of privatization vouchers were distributed to the public at large, one for every man, woman, and child. These could be exchanged for stock at auctions of state enterprises. But the vouchers turned out to be worth less than $20 each. Most people either sold them immediately, investing the proceeds in a bottle of vodka or a sack of potatoes, according to their inclinations, or else placed them with fraudulent voucher pyramids masquerading as legitimate mutual funds.

In the end, the shares purchased with vouchers mostly ended up in the hands of the same former komsomol wheeler-dealers and Red Directors who benefited from other forms of privatization. Idealistic notions that voucher privatization would lead to a broad-based people's capitalism soon turned to dust.

On its own terms, privatization was a success. In just two years, from early 1992 to early 1994, 104,000 state enterprises were privatized. At the end of this period the private sector accounted for more than 50 percent of GDP and some 60 percent of employment.

Yet the more fundamental goal of a dynamic, prosperous market economy was not achieved. The economic rot that had set in during the last years of perestroika continued to spread. Total output drifted downward year after year. By mid-1998, just before the late-summer crash, real GDP had fallen to just 88 percent of its 1994 level, and it is now less than half of the peak it reached during the late Soviet period. Even before the recent crash, 21 percent of the population was living below the pathetically small official subsistence minimum of $70 per month, and tens of millions of workers had not seen a paycheck for months.

Why did privatization fail? In retrospect, the key problem was the failure to establish a system of law within which owners could defend their property and enjoy the gains from increasing its value.

Lawlessness is a multifaceted problem in Russia. It includes the famous "mafias" that engage in widespread racketeering and extortion. Another aspect is a court system that is poorly equipped to render and enforce decisions in routine matters of business law, such as torts, contracts, and shareholder rights. Corruption of government officials, from the local fire department to the cabinet level, is still another part of the problem. Finally, there are whole bureaucracies, above all the tax service, that do not operate according to law in the classical sense of impersonal, predictable rules on which rational plans can be based. Instead, the bureaucracy acts arbitrarily, ignoring violations of reasonable rules in one case while imposing absurd sanctions in others.

No one of these kinds of lawlessness is unique to Russia. Individual examples can be found anywhere, the United States included. But in Russia, the various manifestations of lawlessness are pervasive, institutionalized, shameless, and subject to perverse interactions to a degree that makes for a uniquely hostile business climate. A couple of examples will give the flavor of the problem.

The first concerns a small business in a provincial city. In 1992, Ekaterina Likhoda, a young woman from Nizhny Taigil, received help in setting up a small shop from the British Institute of Chartered Accountants. Six years later she wrote to The Times of London to tell what had come of this well-intentioned effort at people-to-people assistance.

First her shop was bombed when she refused an offer of protection from a local gang. After getting no help from the police, she decided a private protection service was a good idea after all and hired a so-called "sports club" to do the job. When she asked the club to help her resolve a legitimate business dispute, involving the failure of a partner to pay for a consignment, she received no satisfaction, so she rashly hired a competing gang to get rid of the sports club. After this led to a shoot-out, she was beaten nearly to death as punishment for stirring up bad blood between the two organizations. Finally the sports club decided she was too much trouble and, despite a long-term lease, threw her out of the shop in favor of another tenant. In the process she lost everything she owned. She is now unemployed and desperate.

The second example, recently chronicled in Moscow Times, shows that even such corporate heavyweights as the oil company Surgutneftegaz are not immune to trouble. In addition to its Siberian production properties, Surgutneftegaz had what it thought to be a controlling stake in Nefto-Kombi, a chain of more than 100 filling stations in St. Petersburg. Sensing that a far-off owner could be outmaneuvered, Nefto-Kombi held a shareholder meeting at which it diluted the parent corporation's control to 11 percent and struck its representatives from the board of directors.

For two years Surgutneftegaz fought the action in St. Petersburg courts, but the courts were friendly to the subsidiary and dragged the suit out on technicalities. Perhaps this had something to do with a deal under which city officials receive cut-rate prices when they fill up at Nefto-Kombi pumps. After two years of battling, Surgutneftegaz simply walked away from the dispute, cutting its losses.

Circumstances like these sever the essential link between private property and prosperity. Efforts to pursue voluntary exchanges and investment opportunities that move resources from lower- to higher-valued uses have no payoff. At the same time, there are abundant opportunities to enrich one's self at the expense of others, destroying value in the process. Ownership becomes irrelevant; all that matters is having the ability and the nerve to grab someone else's property as it floats by.

Each day's news brings new examples. Suppose you manage a coal mine - why not sell the coal below cost to a friendly intermediary and pocket a generous kickback? Suppose you run a construction company - why use your revenues to pay wages when you can divert them to your Cyprus bank account? Suppose your business is refining aluminum - why pay market rates for your electricity when you can use your political connections to get it below cost?

Superficially it looks like a market economy: Goods change hands, assembly lines lurch along, freight moves down the rails, but most people get poorer and poorer while only a few grow rich. The mutuality of gains from trade, which not only fuels but justifies the creation of wealth in a true market economy, simply disappears.

Stabilization without Financial Reform

After secure property rights, many people would list sound money in second place on a list of conditions for a prosperous market economy. By early 1998, sound money seemed to have arrived. Inflation dropped below 10 percent a year and Russia launched a new ruble, shorn of three hyperinflationary zeros and confined to a narrow exchange rate corridor at about six rubles to the dollar. Western leaders were quick to herald these achievements and the monetary austerity that produced them. Why is it, then, that "monetarism," as restrictive monetary policy is called in Russia, has become a term of abuse?

The answer is that monetary policy was not supported by structural reforms of the state budget or the banking system. Consequently, instead of lasting stability, disinflation only created the conditions for the financial crash of 1998. It is worth looking at just how this came about.

The recent monetary history of Russia begins in the late perestroika period, when the central bank printed vast quantities of money to finance an out-of-control budget, while the government used strict price controls to limit inflation. By the end of 1991, when the Soviet Union fell apart, there were about five times as many rubles in circulation as were needed to finance national income at the low, state-mandated prices. This gave rise to the long lines and empty stores that symbolized the period.

The first major act of economic reform, on January 2, 1992, was to decontrol prices. Given the huge excess money supply, the price level leaped upward, rising by 245 percent in January alone. If no new money had been created, inflation would soon have run out of steam. But when inefficient state industries began screaming that they didn't have enough cash to stay in operation, the reformers lost their nerve. A pro-inflation chairman, Viktor Gerashchenko, was installed as head of the Central Bank of Russia, and an unavoidable one-time jump in the price level turned into sustained hyperinflation.

Gerashchenko stayed in charge of the central bank until October 1994, during which period the annual rate of money growth never dipped below 200 percent. But by early 1995, under the new leadership of Sergei Dubinin, the central bank began to apply orthodox monetarist methods. Inflation steadily slowed.

All this would have been fine had it been accompanied by other policies to reform the state budget and the banking system. Unfortunately, no such reforms took place.

When the disinflation effort began, government expenditures at all levels accounted for more than 40 percent of GDP, a higher figure than in the United States or Japan, and very high indeed for a country of Russia's low income level. Tax revenues were over a third of GDP, also high by international standards, but not high enough to prevent a budget deficit of more than 7 percent of GDP. Under Gerashchenko, the central bank had been willing to print enough money to cover the gap, but if headway was to be made against inflation, something else had to be done. There were three options: Cut spending, increase taxes, or borrow.

The right thing would have been to switch temporarily from printing money to borrowing, thereby immediately slowing inflation and creating a window of opportunity to reform government spending and the tax system. Things got under way well enough in 1995, with annual inflation falling below 100 percent for the first time since reform began. But as the months went by, no progress was made on the budget. Military reform stalled. Tax reform stalled. The federal bureaucracy not only failed to shrink but, incredibly, grew to the point where the government of Russia alone employed more bureaucrats than the whole Soviet Union had in 1990. The deficit remained stuck at over 7 percent of GDP.

Borrowing became an addiction. As the market for government securities neared saturation, interest rates soared and debt service became the largest item in the budget. As ever more securities were sold to pay interest on the old ones, an unsustainable debt pyramid accumulated, just waiting for a shock to send it toppling.

Meanwhile, other opportunities for reform were being lost, one of which was the chance to build a sound banking system. In the early days of reform, banking looked like a sector that might lead Russia to a market economy. As soon they were permitted, hundreds of new, private banks sprouted up. It did not take long, however, for the new banks to discover that taking deposits from savers and making loans to businesses was not the quickest way to get rich. A much more lucrative strategy was to attract central bank credits at interest rates well below the rate of inflation, invest the proceeds in hard-currency assets, and pay off the credits later in devalued rubles.

When inflation slowed, that particular banking scam stopped working, but another one took its place. By 1996, Russian government bonds were paying interest rates of up to 100 percent per year, double or triple the inflation rate. Banks became the largest buyers of Russian government debt, still financing some of their purchases with cheap government credits but increasingly also borrowing dollars and German marks on international financial markets.

Such schemes made the banks so rich and powerful that the seven most influential bankers came to be described as "oligarchs," widely perceived to have dominant influence over the Russian government. Unfortunately, along the way, the banks failed to develop into true financial intermediaries. Instead of being used for loans to businesses, all available funds were sucked into the black hole of the government debt market.

The private sector, already hampered by lawlessness and high taxes, was further choked by the high cost of working capital. A large segment of Russian industry was driven out of the monetary economy altogether, into what has been called the "virtual economy" - a system that operates by the use of barter and monetary substitutes. The lack of transparency of barter deals makes it easier for firms in the virtual economy to evade taxes, something with which one can sympathize, given how high capriciously enforced taxes are.

Still, massive tax evasion caused the government's debt pyramid to grow faster than ever. Meanwhile, the same kind of shadowy barter deals that managers used to cheat the tax authorities also helped them cheat their own shareholders and workers.

Democracy without Social Justice

The economy that Russia inherited from the Soviet Union was so hypermilitarized and ridden with structural distortions that reform could never have gone smoothly. Mistakes were bound to be made, as they were in such success stories of post-communist transition as Poland, the Czech Republic, or the Baltic states. But mistakes can be corrected and their consequences endured so long as democracy and social justice provide essential popular support for reform - so long as people feel that burdens are equitably shared and that they have a stake in the future.

Russia has acquired the forms of democracy. Elections are held in which opposition candidates are usually allowed to compete, and votes (with only occasional exceptions) are counted accurately. The country has a constitution, although one that is not always observed (except for the clauses that give lopsided power to the president). And it has a parliament, which the executive branch has only once blasted out of its headquarters with tanks. But post-communist Russia has not achieved social justice.

To be sure, not everyone agrees on what social justice is. There is the classical liberal model that emphasizes freedom of economic opportunity and the right of people to enjoy the fruits of their own labor. There is the social democratic model, which seeks social justice through redistributive taxes and transfers. And there is the model found in several Asian economies in which government help for the poor relies not on transfer payments but on investment in human capital through health care, education, and building rural infrastructure.

This is not the place to argue the relative merits of these models. It is enough to note that examples can be found of countries and periods in which each has worked well enough to produce supportive democratic majorities for predominantly, if not purely, market-oriented economies.

The Soviet Union had its own model of social justice. In return for acquiescing to the political dominance of the Communist Party, people received a low but guaranteed minimum basket of housing, education, and health care plus a poorly paid but secure job and an early retirement. Although by no means egalitarian, the system did to some degree keep the privileges and pleasures of the powerful out of view of the masses. Soviet leaders never dared to subject the model to the test of free elections, but they were largely successful in keeping social peace.

The tragedy of post-communist Russia is that it jettisoned the Soviet model of social justice without adopting any of those common among successful market economies. The demise of social justice came about in three great waves of confiscation.

The first was the hyperinflation of 1992-1993. Under the Soviet system, people were allowed to save, but not to invest. By the time they retired, many people did manage to save significant amounts, but the only saving vehicles were currency or accounts at the state savings bank. Part of the Soviet social contract was that prices would be kept stable, so that when those savings were spent to supplement meager pensions, the money would have the same purchasing power as when it had been set aside.

Russia's reformist government decided not to honor the old social contract. During 1992 and 1993, the price level increased by 24,500 percent. Money that would have bought a retirement cottage in the south for an arctic miner and his family would now buy a winter coat. Money a teacher saved for a coat would now barely buy a pair of shoelaces. Money saved by a pensioner to pay for a decent burial would barely buy a candle to burn in church. For the reformers to have resisted inflation would have annoyed powerful industrial and banking interests. It was easier to let the miners, the teachers, and the pensioners take the hit.

The second great confiscation was a by-product of privatization. In the Soviet system, industry belonged to the people. Of course, they didn't get to vote for their boards of directors or collect dividends, but they were not entirely neglected. The mine or factory where people worked typically provided their housing, schooling, and medical care, as well as such fringes as summer camps for their children.

What to do with all this social infrastructure was a big problem in privatization. Leaving the burden on privatized firms would hamper their chances of surviving in the market. Shifting it to local government would require budgetary resources that just weren't there.

In the end, much of the social infrastructure was simply dumped. No one took the responsibility to fund schools, clinics, and housing adequately. Private schools and insurance never got off the ground except for the small urban middle class. Outside the Moscow ring road, the quality of social services, far below world standards even in the heyday of Soviet power, deteriorated to levels found in sub-Saharan Africa.

The third great confiscation came during disinflation. As we saw earlier, after the central bank began slowing its printing presses in 1995, the government was not willing to control the budget deficit. As the debt pyramid grew, borrowing from banks and foreign investors became horribly expensive. Casting desperately around for some way to close the budget gap, the government came up with a brilliant new idea: Why not take out a no-interest loan from those same miners, teachers, and pensioners who had so generously financed price liberalization and privatization?

Ask their permission? Don't be silly. Just stop paying them. Between the start of serious disinflation at the end of 1994 and the collapse of the debt pyramid in 1998, payment arrears of the government sector ballooned from less than 2 percent of GDP to over 10 percent. This no-interest borrowing from defenseless citizens totaled a third of all government debt, with payments of wages and pensions running from several months to more than a year late.

Meanwhile, a few people were becoming spectacularly rich. The sight of ostentatious cars, five-story country homes, casinos, and flashy boutiques became as common as the sight of disabled veterans begging on street corners or old men prowling through dumpsters. In comparison with Soviet days, when the privileged party elite bought their caviar in discreet, unmarked special stores and built their country houses on roads closed to public traffic, it was shocking.

Somehow, though, Western boosters of Yeltsin's economic reforms didn't seem to see all of this. For the West, reform became a numbers game. Count the number of privatized firms - never mind if they treat their workers, shareholders, and business partners in a civilized fashion. Count the number of banks and brokerages - never mind if they're just parts of the great pyramid scare. Watch the inflation rate fall - never mind the unpaid pensions. Count the elections - What? The people have the audacity to elect communists to their parliament? Well, at least be thankful that the parliament has no power and Yeltsin can rule by decree to keep reforms on track.

Back to the Future

If one reviews the advice of Western leaders over the last several years, whether in the carrot-and-stick form of IMF conditionality or the cheerleading of "Boris's friend" Bill Clinton, it comes down to one thing: Keep reforms moving forward. But at some point this became the wrong advice. Russia today is in the position of a baseball slugger who has knocked the ball over the fence but then forgotten to touch first base. The fans are cheering him on toward home, but the coach needs to call him back to correct his mistake. As we have seen, Russia has failed to touch not just one but several essential bases.

The situation is not hopeless, but simply moving forward won't do. If the goal of a market economy is not to be abandoned altogether, it will be necessary to retrace some steps and do some things over again.

Take privatization. Its results have been disappointing because it was carried out before the essential legal framework was in place. In addition, since privatization so blatantly favored the rich and powerful, it poisoned public opinion against the whole idea of private property. It is almost as if someone had set out to prove the truth of the doctrine that "property is theft."

There is no point in urging more privatization until these flaws are corrected. Actually, some parts of the problem have already been fixed. A body of civil law - which didn't exist when reforms began - is now in place. Devices to enforce shareholder rights, such as disclosure rules and transparent registers, have also begun to emerge. Adequately funding these rule-of-law functions of government would help a great deal.

Still, something needs to be done to expropriate the unsavory beneficiaries of past privatization. Ideally, much of this might be accomplished through bankruptcy proceedings. A thorough audit and settlement of claims against firms like Norilsk Nickle or giant carmaker Avtovaz would surely find them insolvent. Their creditors, including unpaid workers, could hardly run them less well than their current owners, who for years have driven them into the ground by diverting revenues and stripping assets.

Unfortunately, bankruptcy procedures are among the least adequately developed branches of the legal infrastructure. That being the case, renationalization, as advocated by Russian leftists, might not be such a terrible idea. That would still leave open the hope of future reprivatization, the next time following fair and transparent procedures.

In the financial area, there seems little sense in urging Russia to stick to orthodox IMF policies of tight money and rigid exchange rates. Those policies do not work in countries that lack budget discipline, a modern tax system, and developed financial institutions. At best they produce brief episodes of illusory stability alternating with episodes of high inflation.

No matter what is done or who is in charge, Russia is unavoidably entering a new episode of inflation. With Viktor Gerashchenko back in charge of the central bank as of September, inflation is certain. Before another attempt is made at macroeconomic stabilization, the microstructure of the financial system needs to be fixed. This will mean downsizing the bureaucracy, radically lowering rates and tightening compliance, and rebuilding the banking system.

As for social justice, it would be presumptuous to dictate a specific formula. But it is clear that Russia is never going to make it as a market-oriented democracy unless its government breaks its centuries-old habit of enriching the ruling class at the expense of ordinary people. A sufficient rule of law to allow people to enjoy their own earnings in reasonable security would be a huge step forward. Where wages and pensions have been promised in return for services to the state, the state should fully honor its commitments just like anyone else. If any money is available and any urge is felt to do something more proactive, the Asian model of public investment in education, health care, and rural infrastructure might do a lot to create a social climate in which market institutions could enjoy public support.

Unfortunately, it is easier to say how to step back and start over with market reform than it is to say who will carry out such a program. It won't be the Gaidars, Chubaises, and Fyodorovs so widely lionized in the West. They had their chance and blew it. It is hardly to be hoped that the job will be done by the new Primakov government, with its economic team of perestroika retreads, or by the kind of nationalist-leftist government that the next round of elections will likely bring to power.

What we are much more likely to see is some kind of "mobilization economy." Elements will include inflationary monetary policy to stimulate demand; subsidies to maintain employment in heavy industry; protectionism; capital controls; and, to gain public support, a payout of wages and pensions, possibly with indexation, along with price controls on basic consumer goods. An optimist might hope the package would include expropriation of the bandits who have dominated Russia's pseudo-market economy to date. A realist might laugh at that hope.

Such a policy package just might halt the current downward spiral, although it is hardly a recipe for long-term prosperity. But people in Russia today, exhausted and cheated in their hopes, are hardly looking for prosperity. Indeed, most of them are thinking only of survival.

Given the cynicism and apathy of the public and the back-to-basics statism of a political elite still headed by alumni of the Soviet Politburo, what does the future hold? Most likely a long period of drift and stagnation, such as Argentina experienced during decades of populist and military governments. This is not what the IMF wants, not what the Clinton administration wants, not what the boys at Harvard want, and certainly not what the readers of this magazine would want. But for the moment, it seems to be what the Russians want, and what they are likely to get.

Edwin G. Dolan ([e-mail]) is president of the American Institute of Business and Economics (www.knight-hub.com/aibec/), an independent American MBA program in Moscow.