Finance: Research, Policy and Anecdotes

Have Western economists lost Russia?

There is currently a discussion on how Russia went from an almost ‘normal’ country to an authoritarian kleptocratic regime that is about to slip into a totalitarian dictatorship. Some argue that the reform shock therapy in the late 1980s and 1990s is at the core of this development, having caused significant socio-economic upheaval if not chaos, impoverishing large parts of the population, while at the same time allowing the emergence of oligarchs.  When Putin came to power in 2000, his promise of stability was welcomed by many if not most Russians, which ultimately allowed his shift towards an authoritarian kleptocracy. So have the Chicago boys lost Russia for the democratic world? I am not convinced, as I will argue in the following.

 

There were two major schools of economic thinking about the optimal transition process in the late 1980s and early 1990s – the gradualist approach and the shock-therapy approach.  The former has focused on a step-wise approach to the transition from a planned to a market economy, allowing for institutional experimenting and proper sequencing. Shock therapy, on the other hand, involves sudden and rapid introduction of market reforms, including ending price controls, stopping government subsidies and moving state owned industries to the private sector, with the objective of getting beyond the point of no return and overcoming entrenched opposition to reforms. Both Russia and Poland undertook reforms in the spirit of a shock therapy, while Hungary and China are often quoted as examples for the gradualist approach.  Have different approaches to economic policy reforms resulted in significantly different economic and political outcomes? The examples above suggest that no and I am not aware of any academic evidence to this effect (happy to be contradicted, though!).

 

Enter the ”institutionalists” who argue that it is not about specific policies but about the quality of the underlying institutions that determine the consequences of economic reforms for economic and political development. So, for example, privatisation by vouchers can have very different long-term effects, as the experience of Russia, Slovenia and Czech Republic show (independent of the question whether this is per se the optimal form of privatisation or not). The transition started with the rapid destruction of the institutions supporting socialism in all transition economies. The building of new institutions supporting a broad-based market economy, however, varied significantly across transition economies, with societies taking sharply different paths during the first decade of transition and ultimately political and economic development.

 

In a paper with Luc Laeven, published back in 2006, we provide evidence for the institutional theory in explaining variation in growth across transition economies during the first decade after the fall of socialism.  We also find no evidence for any significant impact of policy reforms for this sample of countries and time period, nor for a positive impact of future EU membership (although future EU membership helped the development of institutions during the 1990s and thus indirectly economic growth).

 

We also show that institutional development is based on the behaviour and the incentives of the elite during the transition period. In some countries, the elite actively fostered a transition to a market economy with a broad base of participants in the economic and political life through the provision of basic property rights and rule of law. In other countries, the elite was mostly concerned with securing for themselves property rights in the formerly state-owned enterprises to extract economic rents and thus securing economic and political power in the post-transition society. We refer to these two opposite transition experiences as “catalytic transition” and “extractive transition.”  We conjecture that the behaviour of the elite during transition was largely determined by two main country characteristics: the endowment with natural resources and the entrenchment of the ruling elite during the socialist period.

 

First, given the surplus character of natural resources, the elite in resource-rich economies at the beginning of the transition period was most interested in securing the property rights over these resources that gave them a power base. It is generally easier to materialize short-term profits from natural resources than from fixed assets such as manufacturing plants, equipment and machinery, because proceeds from natural resources depend less on the creation of a functioning market economy, on human capital, and on R&D investments. This is a version of the natural resource curse, familiar to most economists. Second, one of the consequences of an extended time under socialism and the consequent centralization of power was the absence of any political opposition, or even civil society institutions and social networks, such as churches, political clubs, and trade unions to challenge the power of the political incumbents. These entrenched political elites are less inclined to share economic and political power during the transition process because they can use their political power to extract rents.

 

Interestingly, we used Belarus and Ukraine as example to illustrate this entrenchment: “Upon gaining independence, the communists remained in power in both countries. The Soviet economic and social structure had provided a social safety net, and the need for economic reforms was not apparent. Because of its strong historical link to Russia, Belarus remained a close ally of Russia and institutional development has been one of the lowest among all transition economies. Ukraine also made little progress in structural reform during the initial transition years and the business environment is still plagued by government interventions, weak property rights, onerous taxes, and corruption.”  Interestingly, both countries fare somewhat better in terms of natural resource reliance (well below Russia, other FSU countries and some Eastern European countries).  Obviously, time spent under socialism is not a permanent destiny as the difference between Belarus and Ukraine has shown over the past 8 years.

 

Returning to the initial topic, if economists have failed Russia it is not in providing wrong economic policy advice but not realising that without the proper institutional development participatory democracy and an open and competitive economy and society are not possible to develop. We are still trying to figure out how to overcome the curse of history and natural resources, but we know that institutional development is where the focus should be.  Put differently: economic reforms without the necessary institutional underpnning can easily go wrong.

 

These findings should also make us sceptical about a democratic future for Russia after Putin. Yes, countries can break out of the cycle of entrenched elites, rent-seeking and extractive institutions, but an exclusive focus on economic reforms is not sufficient. The building of inclusive institutions that can underpin both participatory democracy and an open and competitive market economy takes time, the right incentives and good leadership.  None of this has been in place in Russia over the past 30 years.