What happened to Russia?
Did free market policies cause Russia's economic decline in the 90s? I think not
In theory, Russia was example number 1 to show the superiority of neoliberal success.
In practice it didn’t end up so.
Russians queue for sausages in 1992. Source
Russian incomes dropped by 50% in the 11 years from 1990-2000 while China, which went much less in the direction of free markets and economic liberalization, had its incomes rise 3 times. And Russia underwent a painful financial crisis in 1998 which involved a default on its debt and a large devaluation of the Ruble.
I’ll be drawing heavily from two books in this post: No Precedent, No Plan by Martin Gilman and Once Upon a Time in Russia by Ben Mezrich. No Precedent, No Plan is the memoir of a senior IMF official in Russia. Once Upon a Time in Russia by Ben Mezrich is a non fiction thriller about the life of Russian oligarch Boris Berezovsky.
Was this neoliberalism’s fault? I argue not.
Here’s what went wrong in Russia
Botched privatization
A weak state
The 1998 Asian Financial crisis
Privatization: Outsiders may not apply
The ideal privatization would be like this: The government sells state owned assets to the public. The prices and terms of the deal are public. There is strong demand for the asset, and a wide variety of buyers bid for the asset transparently. Then, the highest bid is given the asset. In an ideal world there are no backroom deals, and any misdeeds are prosecuted immediately.
But this was not an ideal world. In the actual reform process this is what happened: The Russian government gave a 10,000 ruble voucher to each citizen so they could buy stocks in government owned companies. This didn’t go as planned. Managers typically had superior knowledge of their companies and so bought shares with an advantage. And the amount privatized didn’t meet the government's needs to fund spending. So, the loans-for-shares programs was announced.
Loans for Shares
When the government needed money it got people to bid for the right to lend the government money. The Russian government was not in good health then, so you might wonder why people lent to them.
The catch was that the collateral for the loans was shares in very valuable Russian mining companies. If the government did not pay the loans back, the lenders would get the shares. Almost by design it so happened that only a few selected people close to those in the Russian government were able to bid to lend on the loans, and then they were able to get the assets for cheap because the government ended up defaulting on the loans.
Take the example of Boris Berezovsky who along with his Roman Abramovich rigged the auction of the media company Roman Abramovich later admitted in court that he paid bribes to buy Sibneft. Or take the example of Mikhael Khodorkovsky who got Yukos - an oil and gas company under a similar scheme.
Economists Thomas Piketty, Gabriel Zucman and Filip Novokmet show that the income gains in Russia by and large went to the top 10% of society and hypothesize that it was mainly because of the botched privatization. Other evidence disputes the idea that only the oligarchs benefitted from the privatization but rather says that the managers of privatized companies benefited the most.
Either way, it is clear that the privatizations caused a large increase in inequality and had they been done better, it would probably have led to a more equal distribution of incomes.
But I don’t find this a good critique of neoliberal policy (or privatization as policy). The best policy would have been to privatize them in a foreign country or wait till the Russian capital markets were developed enough. It wouldn’t have been to not privatize them. Along with that despite the inequality, privatization did improve the efficiency of these firms.
A Weak State
In 1991, there was a coup attempt. Then two years later there was another coup attempt. And in between these two attempted coups there was the collapse of a superpower. The Soviet Union disintegrated into its constituent republics. For sometime, there could have been nuclear terrorism if the USSR’s arsenal had fallen in the wrong hands. And in between all of that, there was rebellion and a minor civil war in Russia. Unsurprisingly, this meant the new Russian state was short of resources. Along with that there was political instability in Russia. Boris Yeltsin dismissed 4 different Prime Ministers from 1991 to 2000 apart from himself. There were 9 finance ministers in the years, making it hard to formulate policy. And in 1995, the State Parliament was run by the Communists who refused to cooperate with the Yeltsin administration.
And so the Russian state had a few problems
Lack of power to collect taxes
No accountability on spending
No data
The tax problem
One of the main distinctions of a modern state is that it is able to tax its population. When large scale tax evasion occurs to the extent that tax revenues are low enough that it impacts government functioning, it shows that the state is not strong enough.
This was one of the major problems facing the Russian state in the mid 1990s. In 1996, tax collections were so low that government wages were not paid in full. Yeltsin was reportedly furious. A Temporary Emergency Tax Commission (VChK) was created, but it was a major failure. But why did this happen?
The Russian tax system was taken from the old Soviet one, without the concepts of profit and loss in a market economy. The soviet tax system calculated taxes as a markup on costs, so it was impossible for it to imagine firms selling at a loss. Just like this, several poorly thought out tax schemes existed, leading to tax evasion.
There were protection rackets by criminal gangs at the lower level, leading to taxpayers paying both taxes and “taxes” to the criminal protection rackets. Naturally they were angry about this, and started to pay less to the actual government.
The Spending problem
Government spending was a black box in Russia. Despite large amounts of technical assistance from multilateral institutions, there was no work done on a federal treasury system till 1997. And after that, it was only functional in 1999.
Until 1994, government agencies could borrow without the finance minister’s authorization and until 1995 there was no auditing of the non-power ministries. Even after 1997 when the auditors were established, they did not have control over the power ministries. It was also well known that Gazprom - the natural gas monopoly - was under the prime minister’s protection and so could not be touched.
The Data Problem
One of the biggest problems Russian banks would face is that they borrowed in foreign currency, but earned in Rubles. So when the Ruble collapsed, they were unable to pay it back.
Ideally the Central Bank of Russia would regulate the banks, and they would have an idea of their foreign exchange exposure. But the Central Bank of Russia too, was flying blind. To quote from No Precedent, No Plan
Under Dubinin and Alexashenko, the CBR set up a special unit, the operations department (OPERU II), to monitor the conditions of the largest fifty banks. The process of improving reporting was gradual, and when it counted, it was clear that even the CBR management did not have a complete up-to-date picture of short-term exposure, especially off – balance sheet liabilities denominated in foreign exchange.
And even after the CBR didn’t have good data. To quote again from No Precedent, No Plan
Nor was the CBR cooperative in providing information that it also did not seem to have readily available. This lapse was all the more surprising in view of the special supervisory unit, OPERU II, set up to closely watch the largest banks, but we now know what we did not know then: it was just a fig leaf, and the banks were reporting garbage data to it
All of these would hit the Russian government hard when the Asian Financial Crisis hit.
The Crisis hits
In 1998, there was a financial crisis in East and South East Asia. Capital fled from these countries, and their currencies collapsed. Their economies also collapsed during this time. Demand for Russian oil exports was at an all time low, and the price of oil crashed.
Prices fell from $18 a barrel to $13. The cost of production for Russian oil companies was also around $13 a barrel. Then during this, Yeltsin dismissed the Prime Minister and appointed an acting PM.
Due to the worsening situation in Asia and economic weakness in Russia, investors started to flee Russia. A $2.1 billion auction for the state oil giant didn’t get even a single bid, and the Ruble started to face selling pressures. At the same time, the government was unable to sell even a single government bond.
The press was dominated by articles calling for an IMF bailout, and while the IMF did approve a $11 billion loan package, it didn’t help much. Money kept fleeing Russia. To quote again from No Precedent, No Plan:
As the managing director in charge of proprietary trading at a major London brokerage with one of the largest non resident holdings of Russian government securities explained to me at the end of July 1998, “ All the key players in the Russian market are nervously watching the exit — it is critical to be one of the first ones out when the stampede begins. ”
By August, investor perception had deteriorated to the extent that no news was taken as bad news. And then the storm hit.
The Russian banks which had borrowed in foreign currencies were now facing margin calls because the values of their portfolios had fallen. To avoid default, they started to sell their government bonds and it became a fire sale.
The stampede began on Russian government bonds and yields jumped up to 160%. The CBR also faced problems with defending the Russian currency, and its reserves fell by half a billion in just a week. The Russian government’s problems began to compound this time.
They couldn’t collect enough taxes to pay off their debts. Their spending was unconstrained and the lack of a treasury system made it impossible to track what to cut. And because the CBR didn’t have data on banks’ foreign currency liabilities, they couldn’t target liquidity support.
The crisis ended after the CBR lent money to Russian banks, and devalued the Ruble. It fell from 5 Rubles a dollar to 30 Rubles a Dollar.
Who’s to blame?
In the end, this was a horrible decade for Russia. But it's not very clear that the culprits are the policies of privatization, macroeconomic stabilization and allowing free markets. The only place where some blame can be given to the IMF’s recommendations is privatization. (Gilman denies that the IMF wanted it immediately, but other IMF members like Michel Camdessus and Stanley Fischer did say it was very important)
But even then the solution would have been something like privatizing them in places where there was the rule of law and strong regulatory action. Perhaps they could have had IPOs in various financial centers like New York, London and Tokyo (and even do it simultaneously in Moscow like how Chinese state owned companies went) and then when Russian equity markets developed, they could have had them trade in Moscow.
But critiques of neoliberal policy when it comes to macroeconomic stability and liberalization of markets are definitely wrong. The problem was that Russia did not have enough state capacity and political stability to keep away rent seekers like the oligarchs. The Duma was also controlled by Communists who wanted a return to the previous system, and were not fans of macroeconomic stability. This led to the government being less bold than what was required on reforms.