Has Russia Been on the Right Path? A Commentary By Kenneth Rogoff Economic Counsellor and Director, Research Department, IMF

August 26, 2002

A Commentary
By Kenneth Rogoff
Economic Counsellor and Director, Research Department, IMF
August 26, 2002

In June, the designation of Russia as a "market economy" by the U. S. Department of Commerce—and the announcement by the European Commission that it would follow suit—was hailed by President Putin as a recognition of how far Russia has come ten years after the dissolution of the Soviet Union. This designation comes at a time when crises in some Latin American countries and U.S. corporate scandals have provoked soul-searching in many quarters about pro-market or "neoliberal" policies.

So it is natural to ask: Has Russia been on the right path? And where is it headed?

To some Western observers, the answer to the first question is an obvious "No." For instance, according to the distinguished economic theorist Joseph Stiglitz, Russia should have learned from the "enormous success of China, which created its own path of transition, rather than just using a blueprint or recipe from Western advisors." China pursued a two-track approach, pursuing faster market reforms along its coastal regions than in the hinterland.

But it is unlikely that China's successful strategy could have been pursued in Russia. China started its reforms with "the advantage of backwardness": it was one of the poorest countries in the world in 1978. Today, after 20 years of growth, the average person in China earns about 800 dollars annually, half the income of the average Russian. Of course, China's strategy has created its own challenges; for example, the IMF's 2002 World Economic Outlook discusses how Chinese banks are dealing with challenges resulting from the slow restructuring of state enterprises.

Another key difference is that in the former Soviet Union, over 85 percent of the workforce was in non-agricultural state enterprises compared to under 20 percent of the workforce in China. This allowed China to reform the state sector slowly while it grew by transferring surplus agricultural labor to township and village enterprises. But Russia needed to end the subsidization of the state sector to free resources for the new non-state sectors of the economy.

The best evidence that the two-track approach would not have worked in the transition economies is that such an approach was in fact tried in some countries, and abandoned. In the mid-1980s, Mikhail Gorbachev in the Soviet Union, Janos Kadar in Hungary, and Wojciech Jaruzelski in Poland did try a Chinese-style approach of limited reform. However, the power of the center had been significantly eroded so that it was simply not possible to implement effectively such reforms, even ignoring the far greater complexity of privatizing industry rather than agriculture. It was the failure of these attempts that led to more aggressive efforts toward a market economy.

But even if a two-track approach couldn't be followed, shouldn't the transition have proceeded more gradually along its single track? Shouldn't the legal and institutional reforms needed to support a market economy have been carried out first? This view is also held by many "gradualists", including not only Professor Stiglitz but also the noted Harvard University Sovietologist Marshall Goldman. They argue that existing institutions should have been abandoned only when the new institutions, e.g. for financial market oversight and taxation, were functional.

The gradualist view seems to be that if only Russian leaders could have kept communism going for 20 more years while they sent bank regulators and tax inspectors for Western training, everything would have been better.

This is improbable for at least a couple of reasons. First, it is unlikely that market institutions could have been developed in a laboratory setting and without actually starting the messy transition to the market. Institutions take a long time to nurture and the institutions that are there today, however imperfect, might well not be there if the effort had not been started ten years ago.

Second, it is unlikely that there existed within the Soviet Union organizational and social capital which would have allowed the existing structure of industry and the level of output to be maintained while new capitalist institutions were being developed. Much of the capital that underpinned economic activity under central planning had decayed before the collapse of communism; indeed, this decay was a major reason for communism's collapse. Some new institutions therefore had to be created quickly.

Of course, to say that Russia could not have followed a gradualist, China-style path is not to say that everything was done correctly or to condone the extreme examples of corruption, particularly in the area of privatization.

There was an intellectual case for rapid privatization. Rapid transfer to private hands, given appropriate competition policy, would lead to a more efficient and rapid restructuring of enterprises than if left in the hands of the state. Some advocates of rapid privatization were truly motivated by considerations of fairness, a desire to give ordinary citizens a stake in the economy. More important, they also perceived a need to seize the window of opportunity that had opened for privatization before the state bureaucracies regrouped and resisted the process.

But the actual experience revealed the pitfalls of the rapid privatization approach. In the Czech Republic, for instance, the first phase of rapid privatization did indeed transfer assets to millions of ordinary citizens. Subsequently these assets ended up being consolidated in investment funds. But there was no genuine restructuring of enterprises, either because the investment funds lacked the capital to develop them or because the funds were in turn controlled by state-owned banks that did not impose so-called hard budget constraints. The weak growth performance of the Czech Republic in the late-1990s, relative to other Central and Eastern European countries, can be attributed in part to its weak enterprise reforms.

In Russia, the country's mass privatization program of 1992-94 transferred ownership of over 15,000 firms into private hands. Reformers recognized the importance of creating incentives for restructuring through the establishment and enforcement of a clearly specified legal and regulatory framework, and development of bankruptcy legislation. Nevertheless, in part because of less-than-perfect implementation, the privatization did not lead to self-induced restructuring of firms. It was hoped that secondary trading would introduce outside ownership, and that transparent methods would be used in the second wave of privatization of remaining firms still in state hands.

Neither hope was fulfilled. Insiders were wary of relinquishing control; workers feared the cost-cutting that might occur under outside control, and managers found it easier to keep enterprises alive by lobbying the state for subsidies than to foster competitive performance through involvement of outsiders. The second wave of privatization, in particular the so-called "loans-for-shares" scheme, systematically favored parties with ties to government interests.

It is clear now that creating incentives for genuine restructuring of enterprises was more important than moving property into private hands. Imposing hard budget constraints to force out the chronic loss-makers among the enterprises turns out to have been quite important in inducing restructuring even if the enterprises were still in state hands.

What lies ahead for Russia? Several developments suggest that cautious optimism about the country's prospects is warranted. After many false starts, macroeconomic stabilization—a commitment to low inflation and fiscal responsibility—appears to have taken hold in the period since the 1998 crisis. This is a welcome development as the experience of the transition economies has shown that stabilization is a prerequisite for sustained growth: many Central and Eastern European countries and the Baltics, who had early and durable stabilizations, have had better growth than countries which have been laggards.

Though it is too early to render a final judgment on the success of Russia's "dirty privatization," some feel that it may be starting to confer some broad-based benefits. MIT professor Rudi Dornbusch, arguably the world's leading international macroeconomist until his untimely death this July, said in a March 2002 interview: "It's true that the Russian reformers ... privatized without much care for niceties ... Yet, in the end, it worked. The massive privatization and restructuring of state enterprises is paying off ... Now you can begin to think about attracting foreign capital. Would that have been possible if Russia was advised by someone who would still be drawing perfect privatization schemes in his head?"

Acceleration of structural reforms in many areas and greater political stability are other positive developments. High oil prices have helped performance; Russia's ability to preserve these gains in the event of a decline in oil prices will be a critical test.

To me, personally, another hopeful sign can be found in this description by Lilia Shevtsova, a Moscow scholar, of her 19-year old son and his friends: " ... I am amazed. These are people who are absolutely free of old stereotypes. They don't remember communism. They have no fear or inferiority complex. They are ready to live in this global environment. They live on the Internet. My son spends nights at his computer chatting with friends in all countries about chess, about music ..." The sheer normalcy and universality of this description provides me with hope that Russia is on the right path.


This article is excerpted from the author's forthcoming IMF paper (written jointly with Prakash Loungani and Andrew Berg).


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