Exploding the Myth About Economic Reform In Russia

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Exploding the Myth About Economic Reform In Russia

March 9, 1993 32 min read Download Report
John R.
Senior Visiting Fellow

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930 March9,1993 EXPLODINGTHEMWMS ABOUTECONOMIC REFORMINR USSIA INTRODUCTION The highly publicized hardships of Russias transition to a market economy have led many to conclude that ke market reforms have failed in Russia. Increasingly, Russian opponents of reform are charging that hsident Boris Yeltsins policy of shock therapy the term for a rapid transition to a market economy-has destroyed the economy and created nothing but misery for millions of Russians.

It was inevitable that Russia would encounter severe problems as it moved toward a market economy. What is being attempted, after all, is nothing less than a complete restructuring of the nations economic and political systems. Over seven decades of communist rule, moreover, have left Russias reformers with no market institutions on whichto build. And a siz e able number of former Communist Party apparatchiki well situated in positions of influence and power in the government and the bmaucracy are working, often successfully, to block and even reverse reform Myths that Impede Reform. Reform of any type in any c ountry always disrupts the status quo, and thus angers those who benefit from prevailing conditions. Russia is no exception. The Yeltsin governments reforms face concerted opposition from the militaxy industrial complex old Communist Party functionaries, a nd others who benefitted from privileged positions in the farmer Soviet Union. These opponents of reform, along with naysayers in the West, perpetuate several damaging myths that hobble the progress of reform.They are Myth #l: The policy of radical econom i c shock therapy has been tried in Russia. This is not true. Although the Russian government has adopted important, even radical reforms such as price liberalization, the totality of its =form program amounts to little mare than a package of half-measures, which at best have been half Myth #2 Myth #3 Myth #4 effective. Shock therapy has been tried in Poland and Czechoslovakia-and has succeeded in those countries-but has not been tried in Russia Radical reforms have impoverished the Russian nation. This is n o t true. The problem with the Russian economy today is not radical reforms but their absence. Indeed, instead of being scaled back, credits and subsidies to state enterprises actually have increased, resulting in hyperinflation and the impoverishment of mi l lions of ordinary citizens. And the governments failure to legalize private land ownership and construct a legal regime that protects private property rights has resulted in a paucity of new private-sector job opportunities for Russian workers The decline of Russias industrial sector and the rise of small shops and retail trade outlets is bad for the Russian economy This is not true. Russias industrial sector is outdated and antiquated, and thus produces a surplus of goods neither wanted nor needed by the R ussian people. Its decline, therefore, will free scarce resources for new private sector development in Russias highly underdeveloped service and retail trade sector. This will mate the types of goods and services needed by Russian consumers, as well as t h e capital needed for the development of modern high-tech industry and Western-style free market prosperity Russias unique history and culture give it an inhospitable environment for the development of Western-style entrepreneurial capitalism. This is not true Russias history and culture, to be sure, have created problems unique to Russia that make the establishment of a free market economy there difficult But this has been true in all countries that have embraced entrepreneurial capitalism.

Russias problem s may be more intractable than most, but they are not insurmountable In fact, before the Bolshevik takeover in 1917, Russia had one of the worlds fastest growing capitalist economies. And despite all the difficulties, entrepreneurial capitalism is doing s u rprisingly well in Russia today, accounting for at least 20 percent of gross national product EXPLODING ECONOMIC MYTHS The many myths perpetuated hy enemies of reform are damaging the prospects for a free and prosperous Russia. They affect the political c l imate not only inside Russia but in the West as well. Western journalists adopt these myths and spread them in their coverage. It is very important, therefore to debunk these myths, not only to advance reform inside Russia but to develop in the West a pro p er understanding of Russias problems 2 1 Myth #1: The policy of radical economic shock therapy has been tried in Russia Russias economic reform program is regularly depicted by the Western media as a hastily implemented and break-neck dash to a free-marke t economy. Russia, so the argument goes, is attempting to make the transition to capitalism in one huge leap by means of shock therapy in which market conditions are imposed forcibly across the entire economy. The Russian government supposedly has a sink-o r -swim attitude toward a bewildered citizenry and the ill-prepared state-owned industry alike. According to those who hold this view, the tremendous political and economic difficulties produced by shock therapy have only deepened economic failure in Russia . The pain, they say is not worth the cost because no prospects for success m in sight. What Russia should the market in favor of a more balanced process that is less costly to industry and the public I instead attempt to do, it is argued, is to moderate t h e speed and scale of its move toward I Russian Reality. Russias economic difficulties, however, are not caused by shock therapy. Quite the contrary: they result from the governments failure to adopt a truly radical and comprehensive economic reform progra m . In many mas-control of the money supply, agricultural reform, and privatization, for example-there has been far less structural change than is even minimally necessary for the functioning of a market economy. Far from sweeping away the restrictions that impede Russias private sector the government instead has erected many new impediments over the past year. Even some of Russias liberalizing programs have been cut back or modified because of their perceived negative effects on the economy. The result has b een a package of half measures, few of which have achieved their stated aims, and which collectively often have produced little but chaos. Shock therapy cannot be said to have faiM because it has not yet been med In some areas, there has indeed been exten s ive change. Take, for example, price liberalization-the freeing of prices from government control. In January 1992, the Russian government launched its economic reform program by freeing prices on 90 percent of goods and services. But price liberalization is only one aspect, albeit an important one, of a comprehensive economic reform program. A free-market economy after all, is comprised of much more than f-ree prices. To function effectively, free prices must exist in the complex environment of a free mar k et, which requires private property private businesses, and the soft infiastructm of basic laws and institutions to facilitate 1 David M. Kotz, No More Radical Reform, The New York Times, December 15,1992, op-ed page; Russias Days of Shockllerapy Are Over , The Wall Sfreef Journal. December 16,1992, p. A

10. The article begins with the sentence Shock therapy in Russia is dead, and is subtitled, New [Russian] Premier is Wary of Unbridled Market Forces. This assumes, of course, that the government had, in fac t, adopted a policy of shock therapy which allowed for the working of unbridled market forces. This has not. however, been the case 2. Two steps forward, one step back, one step sideways, The Economist, July 4,1992; Marshall I. Goldman Yeltsins Reforms: G o rbachev II? Foreign Policy, No. 88 Fall 1992; Russia: The sixth wave, The Economist December 5,1992; Eastern Europe: Heading for Reform, Facts, Problems, Prospects. Issue 1: Russia, Deutsche Bank Research, December, 1992; Eleanor Randolph, Russia Reimpose s Food Price Controls: New Premier Rolls Back a Gaidar Reform, The Washington Posf, January 6,1993 p. A

19. World Bank, Russian Economic Reform: Crossing the Threshold of Structural Change,A WorldBank County Study, Washington, D.C., August/September 1992 3 private-sector entrepreneurial activity. Among these laws and institutions are legal ar rangements governing ownership, corporations, labor, pensions, bankruptcy, banking monopolies, and taxation.

Yet legal refm and privatizrition so far have proceeded s lowly. The Russian legal code, for example, still classifi s a significant degree of entrepreneurial activity as crimi nal conduct punishable by law. Since no clear right of land ownership yet exists, more than 90 percent of the farm land is still owned b y the state, as are more than 90 percent of commercial and industrial properties. Significant tariffs and other barriers to foreign trade and investment remain in place. Private-property rights lack adequate legal row tion. Less than 3 percent of the state housing stock has been sold off to residents.

Domestic trade is still largely regulated and restricted by the state. Small-scale privatization has yet to get off the ground in most of Russia? And measures adopted by the central government to promote econo mic reform often are ignored by local and re gional governments.

Mareover, not all prices have been freed from government control. Indeed, the prices of some of the Russian Federation's most important commodities, most notably energy products such as oil, remain fixed at far below market levels. The price of oil in Russia for example, is only 20 percent of its world market price. Yet, because oil is a vital part of a modem, industrialized economy, price controls on it and other energy products have led to gross price distortions throughout the Russian economy. Price controls on oil and energy have proved especially costly since energy exports are the single largest source of Russian hard currency earnings and government revenues. Yet because of price contr o ls on energy products, incentives to produce are lacking, leading to a 30 percent decline in energy production since 19876 B John D. Sullivan Russian Reforms and Entrepreneurship Economic Reform Today, Center for International Enterprise (CIPE), Washingto n, D.C Fall 19

92. According to Sullivan, laws that criminalize entrepreneurial activity are by and large not enfarced today, even though they lire on the books Perhaps, but Russian reformers a nd entrepreneurs still complain of harassment by state officials and insist that not a small number of enmpreneurs are legally punished for legitimate entrepreneurial activity, often by regional and city governments that are less reform-minded than the Ru s sian central government and that often solicit bribes which make the at of entrepreneurship prohibitive. Laws against private-sector initiative could well take on a new life, moreover, in the event of a hard-line crackdown on the Russian "mafia which offi cials typically construe to include honest and dishonest enmpreneurs alike. Central Intelligence Agency (CIA Measuring Russia's Emerging Private Sector Intelligence Research Paper Washington, D.C November 1992.

According to the International Finance Corpor ation, there are between 250,000 and 300,000 smaU shops restaurants, retail-trade outlets and the like in Russia, less than 50,OOO of which have thus far been privatized. Most of the small-scale enterprises that have been privatized, mover, are located in only a few major cities such as Nizhny Novgorod, Moscow, and St. petersburg.

John Lloyd, "Bank row Sting Russian oil output Financial Times, October 11,199?2, World Bank Russian Economic Reform: Crossing the 'Ihreshold of Structural Change op. cit Chapter 14, Reforming the Energy Sector p~. 175-191 4 There have been, of course, many successes in the Russian government's economic reform program. Perhaps the most prominent accomplishment is that Russia has cleared the formidable psychological hurdle of acce p ting the necessity for a transition to a market economy. Still, the fact remains: the government has not yet implemented a comprehensive and far-reaching economic reform program. The Russian economy has been "shocked" not by moving too quickly toward a fr ee market, but by moving too slowly I Myth #2: Radical reforms have impoverished the Russian nation.

What has impoverished Russia is not radical economic reform but a lack of radical reforms. The old command economy is disintegrating, yet a market economy is not rising fast enough to take its place. For example, anti-reformers often blame Yeltsin's price liberalization program for much of Russia's economic misery. In January 1992, the Russian government freed prices on 90 percent of goods and services. Thi s caused a one time price hike of 250 percent, which, it is alleged, impoverished millions of Russians standards. It resulted in a rapid increase in the supply of goods and services, and largely eliminated most shortages. It also has sharply reduced the le ngth and number of queues.

Moreover, because there are fewer shortages from which black market entrepreneurs can profit, suppliers in Russia's informal sector increasingly have been pressured by the market to lower their prices. Price liberalization, there fore, has made Russia's growing entrepreneurial sector more accessible to consumers and moxt responsive to their needs.

What has impoverished millions of Russians is not radical reform but hyperinflation which has resulted from the overnment's failure to adhere to a sufficiently radical and far-reaching reform program. Russian hyperinflation-now running at a rate of more than 50 percent a month-in turn has been caused by the government's continued support of inefficient state enterprises through increased subsidies and easy credits.

The record is clear in this regatd. During the first quarter of 1992, the government tried to rein in spending to curb inflation and give the ruble a stable value. After the initial, one-time price hike of 250 percent in Januar y caused by price liberalization inflation was brought gradually down to about 10 percent a month by late spring. But the government reversed course in April when it substantially increased subsidies and loans to state-owned industries to shield them from market pressures. As a result, the budget deficit rose from 1.5 percent of gross domestic product in the first quarter of 1992 to 11 percent of GDP the following quarter. Spending substantially increased again during the third and fourth uarters of 1992, t hereby driving the quarterly budget deficit to 15 percent of GDP. This was compounded by the explosion of easy credit to these In fact, however, price liberalization has had a positive effect on Russian living gil Q 7 According to a survey done for the Wa s hington Post by the independent Moscow-based Center for Marketing Research, 73 out of every 10 Russians have gotten poorer over the past two years. Their average purchasing power is just 42 percent of what it was in 1990 Moreover, "the average Russian fam i ly now spends 75 and 80 percent of its income on food. up from about 50 percent a couple of years ago Since last October, when this survey was commissioned, these problems have gotten worse. Michael Dobbs Russian Reforms Impoverish Millions The Washington Post, October 1.1992. p. A20 Russia: The Sixth Wave The EconoAst, op. cit. 8 5 by the Central Bank, a change of course brought about by the appointment of Viktor Gerashchenko as head of the Bank in July.

Russias runaway inflation has proved costly for all social classes because it has sharply reduced the value of the ruble, which has declined in value against the U.S. dol lar by 180 percent since only last September and 270 percent since last July. The collapse of the ruble has been a great impediment to c ommercial exchange and to private-sector entrepreneurial activity Indeed, Russian entrepreneurs increasingly are divesting them selves of their rubles and embracing hard currencies, particularly the dollar. But the dol lar and other hard currencies in sho rt supply in Russia, and the government has taken measures to restrict their use.

Consequently, there has been a rise in barter exchange, which is far less efficient and productive than using money and far less conducive to economic growth and develop ment If present trends continue, the inflation rate in Russia for 1993 will be more than 5,000 percent. Although inflation adversely affects all social classes, its burdens are most pain fully borne by the poor and the elderly pensioners, who axe the least eq u ipped to deal with the devaluation of their savings and wages.The resulting 5,000 percent wage &pre ciation most certainly will prove more costly to a poor family than to one well off. The reason: The poor devote a far greater percentage of their wages to the purchase of essen tial goods and services such as basic food, clothing, and housing. Among the poor, pen sioners and those with fixed incomes also suffer because they tend to be elderly and thus less able to adapt to theunfamiliar workings of a market economy, and therefore less able to supplement their income through private-sector entrepreneurial activity have tried shock therapy-and the results have been far from impoverishing the na tion. Unlike Russia, Poland and Czechoslovakia enacted such far-re a ching economic measures as rapid price and trade liberalization; privatization, particularly of small shops restaurants, and retail-trade outitits; legal and fiscal incentives to spur new private-sector production; and tight control of the money supply. l o As a consequence of these reforms the economic situation in Poland and Czechoslovakia today is far superior to that of most East European countries Shock therapy works when it is tried. Unlike Russia, Poland and Czechoslovakia 9 Gerald Nadler, Yelfsin to stop Russias dollarization, The Washington Times, October 7,1992, New Decree Tries to Srrengthen Ruble, C0mmersant:The Russian Business Week-ly 44, November 3,1992, p. 5. [The actual decree Presidential Decree No. 1306, October 27,19924s published on page 26.1 10 William D. Eggen, Economic Reform in Eastern Europe: A Report Card, Heritage Foundation Backgrounder No 893, April 23,1992 11 Richard W. Judy, The Czech and Slovak Republics: Two paths for Eastem Europe, Hudson Country Report Number One, August 19 9 2, Hudson Institute, Indianapolis, In- Richard W. Judy, prospeCts for Economic and Political Freedom in Poland, Hudson Country Report, NumberTwo, December 1992, Hudson Institute Indianapolis, Indiana; Val Samonis, Polands Big Bang: Lessons from the First T hree Years, Geonomcs, The Geonomics Institute, Middlebury,Vennont, SeptembedOctober 1992, pp. 6-8; Val& Samonis and Csilla Hunyadi Big Bang and Acceleration: Models for t& Posc Commun~st Economic Tran.#ormation (Commack, New YO& Nova Science Publishers, 1 9 92 6 Pxivate-sector growth and development in Poland and Czechoslovakia dwarfs that of Russia and the countries of Eastern Europe. And inflation in Poland and the Czech and Slovak Republics is but a fraction of what it is in Russia. For example, last year the general inflation rate in Poland was less than 50 percent and in Czechoslovakia, no more than 25 percent. In Russia, by contrast, inflation now is running at a rate of more than 50 percent a month. As for unemployment, it has proved more troublesome b u t has yet to exceed 14 ercent in Poland, 13 percent in Slovakia, and 4 percent in the Czech Republic. Analysts, however, insist that at least one-third of the reported unemployed are actually working in the country's nascent private sector.13 The reason: b oth the Polish and Czechoslovakian governments have taken significant steps to protect and promote new private-sector entrepreneurial activity. This has resulted in a dynamic and growing private sector able to provide jobs to workers displaced by the coll apse or privatization of state enterprises Myth 8: The decline of Russia's industrial sector and the rise of small shops and retail trade outlets is bad for the Russian economy.

One of the main reasons the government has pruceeded slowly with economic refo rm is its fear that too rapid a transition to the free market will endanger Russia's large state enterprises. According to this line of argument, Russia's greatest economic asset is its industrial capacity, which must be preserved during its transition to a free-market economy. As Viktor S. Chernomyrdin explained last December, soon after his appointment as Prime Minister 18 Our country, with its powerful infrastructure, with such wealth and resources, must not become a country of small shopkeepers I'm for the market, and I'm for the economy. qyt I'm not for a bazaar. No reform can work if we totally destroy industry.

Chernomyrdin's viewpoint is based on misconceptions. Modem economies increasingly are sewice- and information-based. They are driven not by l arge, mass industrial production, but by small-scale, high-tech entrepreneurial activity. Indeed, the overwhelming majority of new jobs in the West are created by small businesses, not large fa~tories This is because the modem high-tech revolution and the increasing interdependence of national economies have resulted in smaller and more efficient modes of production than that which were common in the 19th century. Therefore, the 12 Judy, "The Czech and Slovak Republics op. cit Judy Prospects for Economic a n d Political Freedom in Poland op. cit 13 Eggers, op. cit David Lipton and Jeffrey Sachs, Prospects for Russia's Economic Reforms (Washington, D.C The Bmkings Institution, 1993 Otto Ulc The Bumpy Road of Czechoslovakia's Velvet Revolution Problem of Commun i sm May-June 1992, p. 23 14 Serge Schmemann Yeltsin Abandons His Principal Aide to Placate Rivals The New YorkTimes, December 15 1992 15 David Birch, Job Creation in America: How our Smallest Companies Put the Most People to Work (New York The Free Press, 1 987 Derailing the Small Business Job Express Prepared for Representative Richard hey, Ranking Republican, Joint Economic Committee. United States House of Representatives, November 7.1992; Scott Powell The Entrepreneur as the Mainspring of Emnomi? Growth Hoover Institution, Stanford University, 1990 7 i i' success of a market economy today depends on a thriving service and information sector or bazaar, as Chernomyrdin calls it.

For Russia to continue to divert scarce resources to hopelessly uneconomic indu stries will not ensure prosperity but only continued poverty. Among the reasons: It will mean the production of more excess tanks, heavy machinery, trucks, and aircraft, most of which are overpriced and lacking in market value and most of which, therefore , the Russian people cannot use for domestic purposes or for foreign trade. It will mean a continuation of subsidies and credits to state industry and the crippling high inflation that necessarily accompanies a loss of control over the money supply. And it will mean a conspicuous shortage, in both number and variety, of basic consumer goods, food, and housing Benefits of the Shopkeeper Economy. While the inefficient state-run industry should not be saved at any cost, neither should the bazaar to which Chern omyrdin refers be restricted. Free-market economies grow from the bottom up, not the top down.

They develop precisely because of the thousands upon thousands of small shopkeepers and traders who profit by helping their customers obtain needed goods and services.

Indeed, as the history of economic development in the U.S Western Europe, and other industrial countries shows, the profits that accumulate from these small but important ventures are the source of most of the capital need ed for the development of modern high-tech industry. l6 some 70 percent of the funds used to finance new investment; l7 as a result, Chinese gross national product grew at an average annual rate of 9 percent between 1978 and 1988.18 This rise is attributa ble almost entirely to growth in the nascent, small-scale Chinese private sector, which now accounts for more than 45 percent of total industrial output, up from only 23 percent in 19

79. And if agricultural production and the service sector are factored i nto the equation, the private sector accounts for at least 75 percent of total economic output in China.19 In contrast, the state-run heavy industries built by the Chinese communists have contributed nothing to Chinas rapid economic growth over the past d e cade. In fact virtually all of the state-owned enterprises-up to 90 percent of them-are operating in the red. Far from being a crucial element of prosperity, these enterprises are a drag on the economy. Thus, the Chinese government is looking actively for ways to dismantle the worst performers and transfer those which are salvageable to the private sector entrepreneurial activity to precipitate an economic miracle. The nascent private business sectors in these countries are responsible for strong, export-l e d recoveries. In China provides an illustrative example. Household savings in China now account for Not only China, but Poland and Czechoslovakia have used small-scale private-sector 16 L.E. Birdzell, Jr How the Wesr Crew Rich: The Economic Transformation of the Industrial World (New York Basic Books, Inc 1986 17 Sir Alec Cairncross and Dr. Cyril Zhiren Lin, The private sector that is driving China, Financial Times, January 8 1993 18 Goldman, op. cit p. 86 19 Cairncross and Lin, op. cit. When China Wakes, The Economist, November 28,1992 8 1 Poland, for example, exports have nearly doubled from some 8 billion a year in the pre reform year 1989 to approximately $15 billion a year in 19

92. In Poland's first ear of reform-1990-a 4.5 billion trade surplus was r egistered with Western Europe!' More important, the private sector's share of Polish exports has risen dramati ally from 4.9 percent in 1990 to more than 21.9 percent in 1991, and is still growing.

Similarly, in Czechoslovakia first quarter 1992 exports g rew by 17 percent while exports to market-oriented economies grew by more than 45 percent. The marked rise in Czech exports is especially noteworthy because Czechoslovakia was more depen nt on trade with other Soviet-bloc countries than was any other East European country.

Economic recovery in Poland and Czechoslovakia has been driven by spectacular growth in small-scale private-sector entrepreneurial activity. The nascent Polish private sector, for example, now accounts for approximately 45 percent of the country's GDP up from only 28.4 percent in 1989 However, because of the existence of a vast underground" economy in Poland, the private sector's contribution to total Polish GDP is actually much greater, perhaps as high as 60 per~ent All told, during the past three years of reform, the Polish private-sector has created some two million new jobs. It also has launched 50,000 new corporations and 700,000 small businesses that, all together employ more than 55 percent of the work force26 Similar developments h ave taken place in Czechoslovakia. Private retail-trade turnover grew from 10 percent of all retail-trade turnover at the end of 1990 to 40 percent in 1991 Moreover, the number of registered private entrepreneurs nearly tripled in 1991, from 488,000 to 1. 3 4 retail sales in Czechoslovakia have soared, growing by 27 percent in the first nine months of 1992F8 Significantly, economic growth in both Poland and Czechoslovakia has not come at the expense of inflation or unemployment. In Poland, inflation actually has fallen from an annual rate of nearly 600 percent in the pre-reform year 1989 to less than 50 percent in 1992.29 In Czechoslovakia, after a one-time rise in the price index of 25.8 percent in January 199 1 the quarterly inflation rate has stabilized at a rate of less than 3 percent Unemployment has proven to be. wen less of a problem, runnin at a rate of little more than 7 percent in Czechoslovakia and 13.5 percent in Poland? Analysts and officials 3.0 2 And, primarily because of the privatization of re t ail trade 31 20 Samonis, op. cit 21 Eggers, op. cit 22 Judy Prospects for Economic and Political Freedom in Poland op. cit 23 Judy, "The Czech and Sloval Republics,op. cit 24 Judy Prospects for Economic and Political Freedom in Poland op. cit 25 I6id 26 [ b id Samonis, op. cit 27 Judy The Czech and Slovak Republics op. cit 28 Richard L. Holman, "Postcrip ts The Wall Street Journal. November 5,1992 29 Judy Prospects for Economic and Political Freedom in Poland op. cit 30 Judy, "The Czech and Slovak Republics o p. cit 31 [bid. However, the unemployment rate has been higher in Slovakia than in the Czech Republic. In 1991, for example the unemployment rate was only 4.1 percent in the Czech Republic, but 11.8 percent in Slovakia 9 in both countries, however, say th e se figures overestimate the actual jobless total by at least a third sin e they include as unemployed many people who actually have jobs in the private sector Strengthening and Restructuring Russian Industry. Far from destroying Russian in dustry, radical economic reform is necessary to save it. Only by its foxed restructuring and adaptation to world marketconditions can Russian industry be modernized and begin producing goods useful to the Russian consumer.

Once again the examples of Czechoslovakia and Po land axe illustrative. As the reform governments in these countries have cut back on subsidies to the old state industrial sec tor, the result, to be sure, has been a decline in heavy industrial production. But as the in efficient state-run industries dec l ine, they consume less credit, subsidies, and other finan cial resources. This frees scarce resources and capital for new private-sector develop ment, which has grown dramatically in both Poland and Czechoslovakia during the past three years of reform. Pr i vate industry in Poland, for instance, now accounts for some 40 percent of Polish GNP, up from 1 1 percent during the first year of reform. And if private farm production is included in the py, the private sector will account for more than 50 percent of G NP in Poland in 1992.

A comparable withdrawal of subsidies and credits to the old state industrial sector has not yet occurred in Russia. A substantial cut in state subsidies and credits to industry was attempted in the fmt quarter of 1992, but quickly aba ndoned in the face of strong politi cal opposition. Consequently,

e decline of industrial production in Russia has lagged behind that of Poland, CzechosIovakia, and other countries now in transition to a market economy. The result, naturally, has been a meager private sector, one that, to be sure, is growing, but only at a very slow pace and with many accompanying difficulties.

The Russian military-industrial complex, by contrast, continues to enjoy a plentiful supply of resources. But with the collapse of communist rule and the end of the Cold War, Russia has no need for the massive Soviet military establishment. Nor need it retain the wasteful and antiquated industrial operations which made it for example, the worlds largest steel producer, with a stee l output per dollar of GDP fifteen times higher than that of the U.S eight times higher than that of West Germany, and seven times higher than that of Japan. Most of the Soviet steel, of course, was used to produce mili tary hardware, not consumer goods.

A reduction of subsidies and credits to state-owned industry is, in fact, the key to a sta ble fiscal and monetary policy in Russia. It will lead to the collapse of wasteful and inef ficient state enterprises which cannot adapt to an environment of fiscal a nd monetary re straint. But not all enterprises will go bankrupt in the wake of a comprehensive and full fledged economic reform prograin. Some will make the necessary changes and work to harness the newly emerging market farces now at work in Russia 35 3 3 Eggers, op. cit Lipton and Sack, op. cit Ulc, op. cit 34 Samonis. op. cit 10 In fact, a growing number of state enterprises are already adapting to the new conditions of the market35 Some state enterprises m seeking out foreign partners and investors by shifting to new modes of production and by selling off worthless assets.

Clamping down on the refom process and slowing it, all in the name of saving Russias industrial sector, would only hamper these necessary changes and thus would do great damage to the Russian Federations future industrial capacity and potential Indeed, by reducing the incentive to restructure, a slowing of reform would lead to further waste of Russias scarce economic resources and delay modernization of its industry.

The way to save R ussias industrial sector is not to insulate industry from the market and maintain the flow of credits to loss-making state enterprises; rather, it is to press ahead with the governments program of mass privatization. Once Russian industry is in private ha nds, it will become increasingly responsive to the market and thus to the needs of the people. Businessmen then will respond to the requirements of the market, and not to bureaucrats attuned to the political demands of entrenched interests.

Even those ente rprises that close down will nonetheless be salvaged through their sale to private-sector businessmen and investors. In some cases, parts of the defunct enterprise will be adopted by a new, more prosperous enterprises and incorporated into a more profitab l e line of production. In other cases, the enterprises will be broken down into their constituent, raw material parts, which then can be used for trade and development in new market ventures. Regardless of exactly what becomes of the enterprise, however, R u ssia will not suffer an economic loss. Quite the contrary, it will enjoy a net gain, as credit, capital, and other scarce financial resources are put to more efficient and productive use uncertainty, and results in some temporary unemployment as state ent e rprises are restructured and incorporated into the newly emerging market economy. But the appropriate response to this inevitable development is not to step back from reform rather, it is to push ahead with reforms to create new private-sector jobs for wo rkers as quickly as possible.

Myth #4: Russias unique history and culture make it an inhospitable environment for the development of Western-style entrepreneurial capitalism This process of creative destruction is messy and untidy . It creates rapid change and Consequently, it will have to find its own third way that is neither socialist in the Bolshevik sense nor capitalist in the American, West European, or Japanese sense.

Russia indeed has a history and culture that differ marke dly from those of the U.S Western Europe, and Japan. Most obviously, it has had over seventy years of Communist rule, which repressed entrepreneurs who refused to abide by the ban on private-sector trade and initiative. Moreover, it is commonly asserted t h at, unlike the U.S. and Western Europe, Russia was relatively untouched by the Renaissance, the Enlightenment, and 35 See, for example: Kathryn Hendley. Steps on the Road to Privatization: A Preliminary Report on the Saratov Aviation Plant, Center for Int e rnational Security and Arms Control, Stanford University, June 1992; Laurie Hays Russian Plant Weans Itself from Military: Consumer Goods, Airliners Spell Success for Saratov, The Wall Street Journal, January 5,1993 11 other important historical stages co mmon to the West, and thus its culture supposedly lacks an appreciation of the importance of entrepreneurship, private property, self-rule and democracy.

The view that Russian culture would never permit Russia to become a democracy was an article of faith among Western academics and area specialists until the events of 1991.

Surprisingly, this view was as common in Russia as in the West. Similar pronouncements continue to be made, by Westerners and Russians alike, that Russia can never be capitalist values of the market every day. They show by their involvement in the bazaar economy that history moves on, that Russians axe capable of overcoming their burdensome past. They show that Russians indeed are capable of capitalism.

Japan and the Asian Tigers. A lo ok at the spectacular rise of entrepreneurial capitalism in Japan after World War II is illustrative. Like Russia, Japan has a unique history and culture that differ markedly from that America and Western Europe. But every country has its own history and c ulture that influence the ways in which it embraces democratic and free-market institutions. But history and culture in themselves need not pose an insuperable obstacle to the market and democracy. Japan, for example never passed through the Renaissance a n d the Enlightenment; yet, democratic and he market institutions now flourish there?6 But the Russian people themselves disprove this assertion. Russians embrace the Similarly, Western economists commonly asserted in the 1950s and 1960s that capitalism was inappropriate for the peoples of Asia because they had a Confucian ethic that did not value the rugged individualism and competitive spirit of the free market?l Yet, today the literatx c on economic development is filled with references to the important r ole of the Confucian ethic in the miraculous rise of the Asian Tigers.

Hong Kong, the Republic of China on Taiwan, the Republic of Korea, and SingapOre?8 36 Sachs and Lipton, op. cit note that according to Henry Rosovsky, author of JapansTransition to Mode m Economic Growth, 1868-1885, foreign ob servers were extremely pessimistic about the fate of capitalism in Japan and other nations of the Orient With considerable complacency they wrm Wealthy we do not think it will ever become: the advantages conferred b y Nature, with the exception of the climate and the love of indolence and pleasure of the people themselves forbid it Or, The national banking system of Japan is but another example of the futility of trying to transfer Western growth to the Oriental habi t at. In this part of the world principles, established and recognized in the West, appear to lose whatever virtue and vitality they originally possessed and to tend fatally towards weediness and conuption. Henry Rosovsky, Japans Transition to Modem Economi c Growth 1868-1885, Industrialization in Two Systems: Essays in Honor of Alexander Gerschenkron, edited by Henry Rosovsky (New York: John Wiley Sons, Inc 1966 37 Yaichi Itagaki, Economic Backwardness and theTheory of Economic Development, Far Eastern Econo m ic Review, February 19,1957; P.C. Spender, Panncrship with Asia. Foreign Affuirs. January 1951; Peter L. Berger and Hsin-Huang Michael Hsiao, In Search of an East Asian Development Model (New Brunswick Transaction Books, 1988 38 Tom Bethel1,The Riches of t he Orient, Nationul Review, November 7,1986; Berger and Hsiao, op. cit Lawrence J. Eau, ed Models of Development (San Francisco: The Institute for Contemporary Studies, 1986 Where Hong Kong has the Edge, The Economist, August 22,1992, p. 26 12 History and culture are, to be sure, important. In particular, they can create a formidable array of political obstacles to reform. For example, pups benefitting from the old, anti-market ways of doing business seek to preserve their protected status in society by sa b otaging and turning back reform. Certainly,this is true in Russia today where many of the old nomenklatura act as a strong political force that works against greater change But a countrys history and culture, no matter how hostile to democratic and free m a rket institutions, cannot extinguish the universal aspirations of people everywheE to be free and to live a better life. For example, in a 1992 Russian public opinion survey more than 80 percent of the respondents who were 29 years old and younger agreed t hat an enterprise is best run by entrepreneurs producing goods people want. Sixty-four percent o those between the ages of 30 and 59 preferred private enterprise to state-run business A new generation of Russians are already unlearning the lessons of the p ast and learning valuable new lessons for the future-how to survive in the marketplace of either recent Russian experience or more distant Russian history. With the =cent emergence of hundreds of local commodities markets throughout the country, for examp le, Russia has witnessedamarked rise in entrepreneurship the past few years.

Indeed, official government statistics show that the percentage of the Russian work force employed by state firms has dropped from 91.1 percent in 1985 to 82.4 percent in 1990 to 77.2 percent in 1991 According to a 1992 Central Intelligence Agency (CIA) report, the emerging private sector in Russia now constitutes about 20 percent of GNP and employs more than 15 percent of the Russian work force.

Some 25 percent of Russias housing stock, the CIA report notes, has been fmanced privately by citizens and was never part of state inventories. Twenty percent of Russian industrial output in 1991 was produced by semi-private enterprises, primarily firms that were leased from the state and run by autonomous entrepreneurs. And nearly half of all building construction was done by cooperatives or leaseholdings. According to the CIA report, leased enterprises or leasholdings tend to be among the top performers in the economy because workers are usually given [market-oriented], profit-sharing incentives. And although Russian cooperatives have strong ties to state enterprises, the CIA notes that they behave in many ways like independent, [private-sector] businesses They offer salaries linked to pr o ductivity and seek out new customers and avenues of enterprise The Emergence of the Russian Private Sector. None of this is surprising in the wake A2 39 Irina Boeva and Viacheslav Shironin. Russians Between State and Market The Generations Compared, Studi e s in Public Policy, No. 205, Centre for the Study of Public Policy, University of Sfrathclyde, Glasgow, 1992 40 Lipton and Sachs, op. cir. These statistics accurately gauge a trend of decline in the Russian state sector and growth in the Russian private s e ctor. However, they are only gross approximations of the reality and, as such, underestimate the extent of the changes now taking place in Russia. According to one analyst, for example, authoritative figures from diverse sources show that some 40 percent o f the Federations non-agricultural labor force is employed in Russias newly emerging private sector, up from only 21 percent one year ago. S. Frederick Sm, Year One of Capitalism in Russia, speech delivered at a Russian Embassy Seminar, January 15,1993 41 Central Intelligence Agency, op. cil.

This evidence of private-sector entrepreneurial activity disproves the assertion that Russia is incapable of developing Western-style capitalism. Even the CIAS data underestimate the degree of private-sector entrepren eurial activity now underway in Russia because, as the CIA explains, they do not include black market or other unreported private economic activities, which are substantial. An estimated 83 percent of the Russian people, for example, now conduct business i n the black or informal sector of the economy, along with an increasing number of state Russia is no historical accident. In fact, Russia has a capitalist past that is often overlooked. Before the Bolshevik takeover, Russia ranked among the worlds fastest growing capitalist economies. lndustrial production in 1913 was increasing at an annual rate of 5 percent, roughly the same as in Germany and the United States. National output was about equal to that of Great Britain and only slightly behind that of Germ a ny. And per-capita agricultural production dwarfed that of Britain and compared favorably, and in some cases surpassed, that of the U.S.44 Historians cite many reasons for the economic awakening of Russia in the late 19th and early 20th ~enturies.4~ The m o st important were the abolition of serfdom in 1861 the dismantling of the collectively tilled farms and the consequent rise of private peasant land ownership, the creation of a stable and reliable gold-backed currency from 1897 to 1914, and a massive infl ux during the same period of foreign capital and investment that opened Russia to Western trade and investment. The process of refm came to a halt in 1914 with Russias entry into World War I and, of course, was reversed with the Bolshevik takeover in 19

17. Soon thereafter, Russian industry was nationalized, central planning begun, and collective farms imposed on the countryside.

This lost tradition of entrepreneurial capitalism awaits discovery by the present generation of Russians. But thcr are some thin gs from the past-even the Communist past-that need not be rediscovered As Cathy Young, author of Growing Up in Moscow explains The notion that Communist states shield people from the need to fend for themselves-whether that is seen as good or bad-could on ly occur to someone who has no idea what its like to get a decent apartment orchunk of smoked ham in the [former] Soviet bloc. The energy and ingenuity spent on these pursuits would have generated untold wealth if applied in business.

The problem with soci alist economies is not that human initiative and enterprise have been stamped out th Russias Lost History of Capitalism. The explosion of private economic activity in have simply been channeled into consumption rather than production. 8 42 Ibid 43 Sulliva n, op. cit 44 Stanley Fischer, Russia and the Soviet Union Then and Now, National Bureau of Economic Research, Inc Working Paper No 40

77. Cambridge, Massachusetts, May 1992; Arcadius Kahan. Russian Economic History Chicago: University of Chicago Press. 19 89 Mikhail Heller and Aleksandr Nekrich. Utopia in Paver (New Yo Summit Books, 1986 Alec Nove,An Economic History of the USSR London: Pelican Books, 1989 45 Fischer. op. cit Kahan, op. cit Heller and Nekrich, op. cit Nove, op. cit 46 As quoted in: Melanie S. Tamrnen, Kleptocracy-Capitalism in the Soviet Second Economy, Journal of Economic 14 i Even in the present post-Soviet reform era, this emphasis on consumption is still very much the case. The problem, however, lies not with the Russian people, who con t inue to demonstrate extraordinary patience and ingenuity in the face of a bewildering array of state-imposed obstacles to entrepreneurship and private-sector initiative. Rather, the fault lies with a political and economic system that too often punishes i n dividuals for the entrepreneurial activities that are the only hope for Russias emergence from its post socialist economic morass only effective and viable way to achieve economic growth and prosperity is through an enthusiastic embrace of entrepreneurial capitalism. Only a comprehensive and full fledged economic reform program, one that removes the bureaucratic impediments to entrepreneurship and private-sector initiative, can accomplish this task The answer to this problem is not some mythical third way t o economic reform; the CONCLUSION Russia has taken tremendous strides toward economic reform. Indeed, few Western experts thought it could have achieved so much in so short a period of time. Russians have overthrown the communists and begun to embrace dem ocracy and free markets.

Private-sector farming and entqreneurship have grown. And a comprehensive plan for mass privatization of state industry has been developed as well Of course, many problems remain. Russia is suffering from hyperinflation, declining energy and industrial pr oduction, and a lack of private sector entrepreneurial activity.

Because of these problems, many myths have emerged to explain why Russias economy is floundering. Some. say that reform is moving too fast. They argue that the policy of shock therapy is main ly responsible for Russias economic troubles. Others contend that free market reforms are destroying Russias industry. And some experts insist that entrepreneurial capitalism as it is known in the United States, Western Europe, and Japan cannot succeed in Russia. Indeed, say the experts, Russia has a history and culture that differ markedly from each of these three countries and regions and thus must find its own, unique third way to prosperity that is neither socialist in the Bolshevik sense nor capitalis t in the American, West European, or Japanese sense.

These experts are wrong. Shock therapy has not been tried in Russia. Where it has been tried-in Poland and Czechoslovakia-it is largely succeeding. Moreover, the decline of Russias state-owned industrial enterprises is not only a necessary development, but a welcome onethat frees resources for the private sector. Finally Russias historical legacies are not wholly hostile to the rise of capitalism. In fact, to the extent that it has been given the opportu nity to develop and flourish, entrepreneurial capitalism has already proved remarkably vigorous in Russia.

The problem in Russia today lies not with the Russian people. The problem is that Russians have been given too few opportunities and incentives to cr eate a growing economy. The solution to Russias economic problem is not less reform, but more Growth, Vol. 4, No. 3, December 1990; Cathy Young, Creeping Capitalism in Soviet Russia, The American Spectator, March 1990, p. 12 15 reform. The government shou l d press ahead quickly with a comprehensive and full fledged economic reform program that would include continued mass privatization of state industry; a complete freeing of prices, particularly on energy products a thorough program of land reform and agri c ultural privatization, which would include an unambiguous legal right to private land ownership and the elimination of preferential subsidies to collective fms; construction of a legal regime that protects private property rights and includes market-based laws governing such things as ownership, corporations labor, pensions, bankruptcy, banking, monopolies, and taxation a stable fiscal and monetary policy; trade liberalization; small-scale privatization; and currency convertability.

Economic reform, moreover, should be carried out in a wholesale and not piecemeal manner. Russias economy canmt be expected to function when superficial and half hearted reforms are imposed on top of a dying command and control economic system.

Shock therapy is, in fact, the re form strategy that has been implemented successfully by Polish and Czech reformers, who have steered their countries into the beginning of a profound and long-term economic recovery. Russia can duplicate their feat, but to do so it must disregard the doub t s and mythical objections of those who misunderstand not only Russia but the human spirit. Historys only proven path to economic growth and prosperity is capitalism with no adjectives and entrepreneurship with as few restrictions as possible John R. Guard ian0 Policy Analyst 16


John R.

Senior Visiting Fellow