The Heritage Foundation

Backgrounder #854 on Russia

September 15, 1991

September 15, 1991 | Backgrounder on Russia

The Coup's Consequences for Economic Reform


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854 September 12,1991 THE COUPS CONSEQUENCES FOR ECONOMIC REFORM Leonid Grigoriev EL. Wiegand Fellow INTRODUCTION The failure of the August 19 hard-line coup in the Soviet Union has trans formed the political situation in that count ry, sweeping the Communist Party from power and clearing the path for a rapid transition to a market economy and de mocracy. The coup attempt demonstrated the vulnerability of democracy unsup ported by a free market economy certainty, increasing internal s trife between the republics and nationalities, eco nomic and political strikes, and repeated postponement of genuine economic re form. To these factors were added general disarder, a smctural crisis, economic recession and inflation I The eight plotters o f the coup proposed saving the country by turning the clock back and undoing many of the reforms of the past several years. In an irony of his tory, Soviet President Mikhail Gorbachev had reaeated from pvious promises of quick reform. His goal was to prese w e social stability through a slow, piece meal approach to evolutionary change. It did not work bad news for Soviet economic reformers. The good news is that the coup has un dennined the power of those most stridently opposed to free market reforms: the to p bkaucracy of the Communist Party, the KGB, the military, and the enor Prior to the coup, a terrible economic situation was exacerbated by politicalm Good News and Bad News. The failure of the coup has brought both good and Heritage Foundation EL. Wiegand Fellow Leonid Grigcniev is one of the akhitects ofthe 500-Day Plan for radical economic donn discussed in this study. In Moscow. he is a Dept Chief at the Instiate of World Economy and Intemahional Relations.ProfsoyuPlaya str 23, Moscow, 1174

18. U.S.S.R FAX 3107027. mous Soviet military-industrial complex. In addition, Gorbachevs timid and halt ing approach to economic reform has been discredited in favor of much bolder measures ing and backward economy remains With their political victory, Russian Presi dent Baris Yeltsin and his colleagues in the other republics inherit an economic mess. To make matters worse, the crippled Soviet economy likely will be wounded further by the current political upheaval. Even as they embark upon free market reforms, the n ew authorities throughout the country must keep the present economy working or face the prospect of dangerous social and political instability.

For this reason, it is critical that the republics reach agreement on free trade currency and banking xefms, price liberalization, and the development of a com patible legal system in which a modem free market economy can flourish. Eco nomic reforms in th e republics should be designed to be as similar and thus as compatible as possible to enhance the prospects of overall success The bad news is that the long-term problem of reforming a rapidly disintept THE CHALLENGE TO SOVIET REFORMERS Soviet leaders face a daunting task. Mor to the coup, the leaders in the repub lics had been too preoccupied with the political struggle to devote sufficient atten tion to long-term economic reforms. The republics economic reform record was sparse partly because the Soviet g o vernment tied the hands of the republics and frustrated their efforts toward reform. But it is also true that the republics them selves frequently were not free market reform-minded. Short-term political goals and the necessity of securing public support a gainst the central government led re publican leaders to back populist measms harmkl to economic reform. Such measures included enormous wage increases unsupported by corresponding in creases in productivity. The overall budget deficit and excess money su p ply meanwhile, contributed to unbalance the consumer market. These led to the expec Before the coup, all economic ills could be blamed on the central Soviet govern tations of shortages and, predictably, to hoarding ment. Now, however, the blame will shift to the republics. as their leaders mst vast powers for themselves from the central government. No longer can the republics leaders avoid responsibility for the state of the economy. Almost cer tainly, their honeymoon with an increasingly impoverished and impatient society will be short.

Unlike Gorbachev, they will not have a halfdozen years to play with economic experiments. Four years of increasingly inept programs were required before Gorbachev and other Soviet leaders could bring themselves to acknowled ge in 1989 the reality that true perestroika requires radical free market reforms. Even then, they continued to delay their implementation. Gorbachevs refusal in Sep tember 1990 to adopt the so-called 500 Days Plan of radical economic reform wasted an ent i re year. Now, however, the coordinated approach to economic re 2 form that the 500 Days Plan could have pvided almost certainly will be pre cluded by the republics following different paths Economic Tower of Babel. Since the economic reforms of countries s uch as Hungary and Poland are more advanced and better known than those in thesoviet Union, it is instructive to compm some of the principal differences between these countries. Unlike Hungary and Poland, economic reform in the Soviet Union has not been i n troduced by professional economists. The suddenness with which the communist system in the Soviet Union collapsed has allowed the &me cratic farces little time to discuss and debate the merits of diffemt approaches to economic ref- and develop technical e xpertise. Consequently, every politician has his own vision of the economic system to be constructed, a virtual Tower of Babel of economic refm.

Most important, the necessary tightening of the current inflationary monetary policy has been made much mm difficult by the dismantling of central authority.

From the standpoint of monetary reform, it would have been much better if the disintegration of the Soviet Union had followed, rather than preceded free market reforms.

Today three competing economic .ref= p rograms are being discussed in Mos cow. The program advocated by Grigory Yavlinsky, one of four members of the Committee for the Management of the National Economy, recommends the pres ervation of a strong and coherent economic union including an integrat e d banking system, a single cmncy at least for one to two years, and a common interna tional economic policy. Other programs would leave economic reforms in the hands of the republics, thereby slowing the pace of reform IMPLICATIONS OF THE COUP The effects of the August 19 coup on economic reform axe mixed. The first ef fect is psychological relief. Since the December 1990 resignation of Foreign Min ister Eduard Shevardnadzz and the replacement that month of Vadim Bakatin as Minister of the Interior by the r eactionary Boris Pugo, the population has been waiting for a showdown between hard-liners appointed by Gorbachev and demo cratic reformers. During this time, the economy steadily deteriorated, making life for the ordinary citizen even mm difficult. This a t mosphere of political and eco nomic insecurity impeded economic reform. For example, the growth of the pri vate sector, especially the establishment of new businesses, was hampered se verely by a fear of reprisals against entrepreneurs if the communist ha rd-liners took over power. Now the shoe has dropped. The hardliners have made their antic ipated move and have failed.

A second benefit of the coup is that the reactionary communist forces have been clearly identified. Until August 19, most of the politica l leaders of the Soviet Union glibly invoked the rhetoric of free market reform, while in fact advocating profoundly diffmnt approaches. Western observers, in particular, often were mys tified why this apparent consensus on economic reform produced so lit t le in the 3 way of genuine market refcnm. Now, however, the anti-reformist forces behind the coup have surfaced and been capsized by a wave of popular opposition West Misled. Over the past year, the true reformers in the Soviet Union warned their Western f riends and colleagues to listen with reservations to the So viet establishment regarding the course of events. But many in the West, espe cially those in government, were too easily misled by a willingness to believe their Soviet counterparts Many Western journalists too, curiously, were misled easily. Consequently, these Western governments mated Soviet Prime Minister Valentin Pavlovs government as their preferred partner. Only the coup ma& this approach politically untenable. Now all of Gorbachevs former cabinet has been dismissed, including all those upon whom Westem governments were =lying to promote economic reform In contrast, the true refcnmers steadfastly have distanced themselves from the central government since that government rejected the 500 Da ys Plan in Septem ber 19

90. These reformers are now free, politically and intellectually, to help in economic refcnm. The coming to power of leaders such as Russias Yeltsin creates very promising political conditions for radical market reform, but its suc cessful implementation will quire the fullest cooperation between economists and politi cal leaders.

The failure of the coup has created an excellent opportunity to destroy the power of the nomenklatura, the Communist Party bureaucracy which controlled th e economy and was capable of frustrating all reforms in recent years. By refus ing to share power with the emerging democratic forces throughout the Soviet Union and by clamping down on private economic activity, the nomenklatura in the central government was able to force Gorbachev to slow his reforms The local nome~uturas resistance to reform arose from a desire to protect its members rank and social standing (including privileges) in society. Its special place in the system was derived from its control o ver the local economy. Now, if the nomenklaturas power is broken as a result of the coup, businessmen and en trepreneurs will have considerably more opportunity to operate. Nevertheless there Emains the danger that the population may come to regard the en t repre neurs in the same negative light as they now do the nomenklatura on the economy and on economic reform. To begin with, the social and political risk of entrepneurial activity has been reduced substantially. The same is true for fareign investments. N o longer is there the threat that property and capital will be seized upon the whim of a bureaucrat nor the danger of criminal prosecution for engaging in private economic activity. In addition, foreign assistance now is much more likely. But at the same time, the erosion of the central governments authority has diminished its ability to implement a comprehensive reform for the entire country Erom the top-in the East European style.

One very big question is how the public will react to radical reforms, esp ecially during the transition period. After six years of false promises and increasing eco nomic misery, it is by no means certain that the population can be persuaded to Risk Reduced. A third benefit of the failure of the coup is the long-tern effect 4 w o rk harder. Public trust in any kind of government reform program clearly is very low Difficult Message. Although the failure of the coup gives new hope to many people much of the population remains passive and large segments fear losing even their present standard of living. No political leader has yet had the courage to tell the people that the transition to a market economy will entail hard work and that only a tiny minority will become rich soon This news may not be welcomed by the large majority of poo r people in the So viet Union. Much of the population dreams of a quick transition to Western living standads. Soviet publications have contributed to this illusion by their emphasis on the rosier aspects of market economies, such as high technology, much as they formerly created a negative image through stories of Western unemployment and inequality of income.

The main goals of the transition-creating an efficient market economy and the foundation for a stable democracy-will inevitably lead to some inequal ity. It will take some time before an emerging middle class will be able to stabilize so inequality is unavoidable, and for what purpose they now must work and sacri fice It is especially important but difficult to convince them of the need to be patient o nce again cial and political life Therefore, it is necessary to explain to the population why THE GOALS OF ECONOMIC REFORM Given that the country does not have a stable government, that it faces the ac tual political secession of several republics, and th a t the republics may each choose a different road to market reform, what should be the goals of the transi tion? The economic and social costs of the transition to a market economy should be minimized. This is essential not only for humanitarian reasons, b ut to avoid a popular backlash that could derail the entire reform process.

Some important areas of reform axe Legalsystem.

The legal system for a market economy does not now exist, and its develop ment will take time, especially in the current unsettled political climate. The disin tegration of existing government structures is creating considerable legal uncer tainty. So, too, is the rapid change of existing laws and regulations. It is necessary to decide first of all which law is valid: union or republ i can. And property rights are still not defined, especially concerning land and real estate. Such laws as bank ruptcy codes, contract regulations, and privatization law should be reassessed and quickly approved. Internal Trade Trade within the Soviet Union overnight has become in effect foreign trade be tween republics. This trade can be damaged by the republics and regional authori ties adopting protectionist measures, such as regulations restricting the export of onsumer goods to other regions. Some autho rities also have extended these re mictions to construction materials and other goods.

The old system of internal trade by governmental command has steadily been replaced by barter. The Soviet government viewed trade by bartering as illegal and inimical to the Soviet economy, but was unable to pkvent it. Attempts by the xntral government to stop barter trading mated obstacles to the flow of goods services, and money. And this slowed even more an already poorly functioning economy This attempt to hinder bar t er trade is certain to continue, particularly as part of a misguided effort by the republics and regional authorities to pmtect local living standards. The central government has lost any ability to prevent it. If the republi can governments persist in tr ying to stop it, the result is certain to be a no-win sit uation in which industrial production and living standads continue to fall.

An additional contribution to this growing disorder is the widespread breaking of contracts. At present, there is no legal recourse if a contract is broken. Nor is there discipline imposed by the market in the fonn of bankruptcy costs and courts Prices.

T he loss of central control over economic enterprises means that price liberal ization is inevitable. Much of the Soviet economy is riddled with monopolies, es pecially in technology. More than half of them involve machinery: a single enter prise may produ c u 60 percent to 100 percent of the Soviet Unions output of cer tain categories of machinery. The republics in which such enterprises are located may reduce production of machinery components needed elsewhere in the Soviet Union. Meanwhile, a monopoly coul d raise the prices of these products for export to other regions and thus cause hyperinnation and price wars. There could well be a price shock as Soviet internal prices rapidly increase to world market levels especially in energy and raw materials.

Such a n adjustment is inevitable in the long run, but the *sent situation will accelerate it. Several products quickly will become sources of trouble, especially oil, cotton, sugar, grain, and other specialized agricultural goods. Their production and distribut ion is largely controlled by the republics. In these conditions, it will be very difficult to monitor consumer prices and to establish a safety net for the poorest segment of the population Currency and Banking.

Both the theory and practice of market refom demonstrate that a relatively strong, stable currency is a prerequisite for market signals to operate. Without these, a true market cannot emerge to replace the quickly vanishing command sys 6 tem of Soviet central planning. In the past, the Soviet Centr a l Bank served as a branch of the Ministry of Finance. Currently, the banking authorities in the vari DUS republics have acquired considerable independence from the Central Bank but remain subordinate to their own Ministries of Finance This can create a mo n etarist nightmare: a dozen uncoordinated republican cen tral banks could emerge that are responsive only to their governments needs. Yet these banks, at least for the immediate future, will continue to use the same com mon currency-the ruble printed only in Russia.

Many of the republics alr%ady have introduced their own quasi-currencies such as coupons for consumer goods. Soon some of them will introduce their own currencies. The republics are doing this primarily for political reasons, many of them valid, and only secondarily for economic reasons. But while it may be inevi table that the republics create their own currencies, the economic consequences of this could be harmful. The republics are in practice liable to wind up with a three tiered currency sy s tem: hard currency for international transactions; rubles and hard currencies for inter-republic business; and local republican currencies for use within the republics. The system will lead to a good deal of confusion, as most goods purchased even in Russ ia come from other republics. And the process of privatization and decentralization of decision-making will mean that most enter prises will have to continue to buy industrial and consumer goods outside of their republics.

It is unlikely that contracts for the export and import of such goods will be de nominated in the local currencies, which will not be immediately convertible. In stead, dollars or rubles are likely to serve as the means of exchange. It is likely that there will be a steady demand for rub l es by most of the republics in order to pay for raw materials bought fiom Russia, Uzbekistan and other resource-rich re publics. The supply of rubles will depend on exports and the prices of consumer goods which will be vulnerable to competition from East ern Europe and theThird World. It would not be easy for the republican central banks to keep the rate of ex change for the local currency high with respect to the dollar or even to the ruble.

Trying to do so, for example, would exacerbate the trade deficit.

Dollarization of trade between the republics is likely, as was the case with the Soviet-East European trading organization, The Council for Mutual Economic As sistance (Comecon). Meanwhile the use of local currencies for economic transac tions within th e republics and the ruble or dollar for intra-republican transactions may be very painful for everyone 4 4 Budget, Fiscal, and Monetary Policy.

The budgets of half of the republics were subsidized by the central government.

This year, some of the republics stopped payments to the central government and tried to balance their own budgets at the expense of the central budget.

This policy will not be sustainable over the long run, however; secession will lead to greater expenditures by the republics on bure aucracy, diplomatic relations law enforcement, and defense, which previously were handled by the central gov 7 I emment. Social welfare programs also will become the responsibility of the repub tican governments. These governments will be faced with inten s e populist pres sure to spend mare money for social security and economic development. A COOT bated fiscal and monetary policy will be a number one priority to prevent pade between different regions of republics from breaking down because of the lack of a stable currency.

A related problem concerns the transfers of government funds between repub tics. The central government previously transferred funds from the relatively pros perous republics of the Baltic states, Russia, and Ukraine to the poorer areas o f Central Asia. But at that time, the prices for raw materials were relatively low. In order to offset the reduction of subsidies, there is likely to be a quick rise of prices for cotton and other export goods from Central Asia. The loss of subsidies and r e sulting hikes in prices may lead to dangerous social instability in the Central Asian republics. The threat is particularly worrisome given the potential long term Muslim fundamentalist threat to secular governments in Central Asia Structural Crisis and Investments.

The economic crisis will be especially hard in the Urals and Siberia in Russias northern regions. There the combination of industry, poor agriculture, and a lack of a developed service or consumer sector may produce severe economic condi tions.

As the central governments investments in these and other regions continue to decline, it will be the task of the Russian government to deal with the structural consequences of lower investment, such as temporarily higher unemployment and decreased produc t ion. Fareign investment and assistance could help to offset the decline of government investment in these regions. The fall from power of the hard-line local authorities mates an oppdty for the introduction of a market economy in these immense and resourc e -rich regions. A special investment fund for foreign investors could be the source of direct or portfolio investment in enter prises that have been transformed into joint-stock companies. Such a fund could also directly assist the process of privatization Privatization.

Privatization is the keystone of major market reform. The republics and regions are likely to pursue similar programs of privatization in housing, retail, trade, and services. Agriculture is more problematic. Vast differences in climate, te chnology products, and traditions mean that the process of agricultural land privatization is likely to differ widely in each republic. Complicated too will be the privatization of large industrial enterprises. The structural crisis and the rapid changes in prices alone will make the valuation of fixed assets and prices of enterprises very diffi cult.

One of the major problems to be addressed is the need to combine speed with efficiency in privatization. Thm is no quick and simple solution for this immense task. The problems of privatization in Russia are complicated and there numer ous obstacles to privatization. These include a lack of capital markets and banking institutions, non-existent property rights, and the nomenkluntrus so-called privatization pr o gram, which is already underway system. Preliminarily approved on July 3 by the Russian parliament, such a scheme would exchange up to 100 million coupons for the securities of about 30,000 enterprises. This approach appears at first glance to have a lot o f advan tages. For example, giving the enterprises away rather than selling them is mm equitable and creates millions of instant shareholders. It also supposedly could speed the development of capital markets and eliminate the problem of evaluating these e nterprises, many of which have little value never been done before, is very complex, and it entails huge administrative and in formational costs. The voucher model could be considered, as in Czechoslovakia for privatizing a few hundred enterprises. It is p robably not the best approach for privatizing the majority of state-owned companies in Russia erly. The combination of selling securities at a discount to workers and a partial free distribution of shares will take years anyway. The equipment and producti o n process of the plant, which will be worthless in many factories, would be handed over to the factory managers. From this moment on, the government discontinues investing in any machinery for any state enterprises. Each enterprise would have to pay for n e w investments The recentpolitical events have clarified one outstanding question relating to property in the Soviet Union: Who owns it? It appears that the republics will take control of the central governments enterprises on their territory. Tensions be tween the republics may arise from not only border or national problems, but from disputes such as access to water in Central Asia.

Over the very long term, carving up the Soviet Unions wealth republic by re public is likely to prove especially advantageou s to Russia. Even by itself, it will be the largest country on the planet. It presently accounts for be-quarters of the Soviet Unions temtory, two-thirds of the nominal value of fixed assets, 51 per cent of the population, and the greater part of the huma n capital, including most of the best universities and scientific institutes. In a country the size of the Soviet Union, the speed by which its various regions will manage &e transition to a mar ket economy hevitably will differ greatly. But the process wi l l be much easier and more rapid if Russia leads rather than follows. The recent triumph of &mop racy in Russia has brought within reach what seemed impossible only a short time ago: the creation of a true market economy and democracy on Russian soil Among a number of proposals to surmount these obstacles is to use a voucher Nevertheless, problems exist with the voucher system. For example, it has Long Process. Privatization will require extensive efforts to make it work prop CONCLUSION The failed coup of A u gust 19 has opened vast new possibilities for the peoples of the Soviet Union. But in so doing, it has also made more urgent the need for more radical free market reforms. No longer can the new democratic lea- post 9 pone greater economic refarm because t h ey fear hardline opposition. In seizing political power, the =formers have assumed responsibility for saving their peo ples from a rapidly approaching economic disaster. They need td exercise this power by moving as quickly as possible toward free market r eform come so quickly with so little time for preparation that the democratic leaders face enormous tasks for which they axe unprepd But deal with them they must, and without delay. While doing so, they must also be careful not to make a bad situation wor s e by adopting mistaken policies Lengthy Agenda. The agenda far immediate action on economic ref- is quite lengthy. Among the most important items m: swiftly creating the legal sys tem necessary for the functioning of a market economy, resisting the tempta t ion to erect baniers to trade with other republics, mating a stable monetary system that avoids both hyperidlation and economic isolation; ducing the rapidly bal looning deficits of the republican governments; ensuring that the grossly ineffi cient and di storted Soviet economy continues to operate as a new market system is mated; and moving quickly to privatize state-owned enterprises in all sectors of the economy.

Only through quick and comprehensive action can the new political leaders hope to avert the worst of the economic scenarios now unfolding. The pwples of the Soviet Union have suffered enough from ill-conceived economic experiments.

The victory of democracy entitles them to the economic liberties from which they have so long been deprived hey may be prevented from doing 50 through fear and confusion. Change has 10

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