By Leslie Evans

Why has the Russian economy done so badly in the transition to a market system since the end of the Soviet Union in 1991? For Yegor Gaidar, former Russian Prime Minister and a powerful figure in current Russian economic policy, this is the wrong question. For Gaidar the question should be how did Russia do as well as it has, and escape the complete economic collapse that threatened to overwhelm it at several junctures over the last decade?

One-time department head at the Communist daily Pravda, Yegor Timurovich Gaidar emerged in the early 1990s as one of the most vocal advocates of the market transition in the Russian leadership. He served briefly as Boris Yeltsin's first Prime Minister (June to December 1992), until he was forced out by Communist hard-liners in the Duma. He has since held various government economic posts, has served as an elected member of the State Duma (1994-96 and 1999 to the present), and is director of the prestigious think tank Institute for the Economy in Transition. Gaidar spoke at UCLA June 14 under the sponsorship of the Department of Economics and UCLA International.

Dr. Gaidar said that it was "inevitable there would be weak and unstable governments after the collapse of the previous regime." One reason for this was the far more important role politics played in the former Soviet economy compared to a market system.

Who Will Deliver the Bread If No One Gives the Orders?

"What is not easy to understand for those who have not lived under a socialist system is the degree to which the economic process is fused to the political process. If there are no markets you have to substitute a bureaucratic system of production control and distribution. If there is no interest in bringing bread to the shops by profit then you must organize this process, give orders on who is to produce the bread and who is to deliver it. You need also to be able to support your orders with strong punishments. The collective farm chairman needs to know that there are strict punishments if he fails to supply grain to the state. Each person needs to know that if they do not fulfill their job they will be out of the party, out of their position."

In Gaidar's view this command economy broke down because of internal limits to such a process of directive production. "It is relatively easy to run a totalitarian regime when 80% of your population lives in the countryside and is illiterate. But it is very difficult when 80% lives in the city and has university degrees. People began to ask why they should submit to these guys that were never elected. This increases the instability of the regime."

This disintegrative process was hastened by the spread of the Soviet Union into Eastern Europe after World War II. "By the early 1980s the region was too educated for the regimes to be stable." When Gorbachev announced that the Soviet Union no longer could resort to unlimited use of force it became evident that these regimes could not survive.

"The East Germans destroyed the Berlin wall. The Poles joined Solidarity. They wanted the European living standards, they wanted freedom. It was impossible to tell them to wait, to say to them that the institutions did not exist to make such a transition."

The Party Was the State

In the former Soviet Union, in Gaidar's view, the transition to the market was especially dangerous. He pointed, however, not to the lack of entrepreneurs but to the lack of government structures separate from the apparatus of the Communist Party. "In Eastern Europe there was a recent history of functioning state institutions. These institutions needed radical change but they existed. In the Soviet Union the essence was that the Communist Party decided everything. Without the Communist Party there was no state, no basis to decide who resolved any question. How should municipalities enforce laws, and which level of law -- soviet, national, local -- was to be dominant?" There were no mechanisms to provide answers.

There had been an economy that absolutely depended on the efficiency of central control. "Now plant directors were getting orders from the ministry, from the local government, from other firms. These orders all conflicted with each other. So the plant directors decided to ignore all the orders."

By 1990 it was clear that the economy was disintegrating. "After the attempted coup of August 1991 the Communist Party was banned, many republics declared their independence, and the system ceased to function entirely. One week after the attempted coup, all procurement stopped. Why should I deliver grain to the state for money that is entirely worthless rather than bartering it for something I need?"

At the end of 1991 Russia's hard currency reserves were lower than 100 million. "The country was bankrupt. The grain reserves could last only until February 1992. No grain, no credits, no working system of grain distribution. This reality was very well felt in the country. If you went to the shops in the autumn of 1991 you would see that they were entirely empty."

There were only two choices, Gaidar said: "Reimpose fear in the countryside to restore the system of bureaucratic distribution, as the Bolsheviks did in 1918. Or you had to start a market mechanism." Gaidar felt that the first choice was not a realistic possibility, "If for no other reason than because the Russian government had no force at its disposal."

There Was No Currency System after the Fall

The country had no living tradition of entrepreneurship. It had no laws protecting property or guaranteeing contracts. But even worse, "We had no money. The Soviet monetary system was a union system. The republics had no control over this system. The central banks of the republics did not even share in the financial information of the union."

A typical mechanism used by the old Soviet Union would be to provide credits to Ukraine by printing money. "This money circulated throughout all the republics," helping to dampen inflationary pressures created by raising the money supply for a single republic. "You needed to regain control over the money supply after the union was gone." At the same time, prices had to be freed from historic Soviet controls to float to reflect real costs of production. Large numbers of common necessities, for example, were for decades sold below production costs and the difference supplied by state subsidies. This had always created a nightmare for any attempt to impose cost accounting on Soviet enterprises. But freed prices would spiral upward too fast unless the money supply could be simultaneously expanded. At this particular moment, however, the all-union central bank disappeared, to be replaced by 15 republic central banks.

"At the very beginning we thought that we could postpone the price liberalization until July 1992, to create a real central bank and a national currency. But at the end of October we saw that we had no chance of survival if we postponed the price liberalization. I was criticized later for not telling the population how difficult the situation was, but this would have been devastating."

Acting first as Minister of Economy and Finance and then as Prime Minister, Gaidar and his government decided to float the majority of prices. "Next was to remove all import barriers. We removed all tariffs and controls over imports. There was no system of customs anyway at that time and we sought to recognize that."

Hyperinflation and the Debate over the Single-Rouble Zone

Beginning in 1992 the Russian Federation government tried to promote a single-rouble federation to encourage economic integration of the departing republics. This bid for currency stabilization was paralleled by drastic cuts in government spending in the Russian Federation to halt the rampant inflation. "The Russian economy was 60% of the Soviet economy. Our idea was not that we could stop inflation, but that we could stop hyperinflation that would paralyze the economy." The Russian government cut its budget by 80%: "We cut subsidies, cut the investment program, cut education and health care.... To some degree it worked. We had an evident decline of the inflation rate from 350% in January 1992 to 10% in the summer of 1992." Most Western estimates put Russian inflation at its worst point in 1992 at a 2000% per year rate.

There were many stormy debates in the efforts to stabilize a new currency. At the end of 1992 all 15 former Soviet republics joined the IMF, including Russia. The IMF initially advised them to maintain the rouble as a single currency. Gaidar became an outspoken opponent of this policy and urged the republics to create their own currencies, which they did in 1993. Gaidar was widely accused of taking this stand because many of the Central Asian states were poorer than Russia and Russia had a better chance to go it alone.

In his UCLA talk Gaidar said he had been convinced to abandon the rouble zone during the contentious negotiations between Russia and Ukraine in Kiev in April 1992 over control of the Black Sea Fleet. "The Russian government was promoting printing money to cover expenses we had with Ukraine to finance the Black Sea Fleet. It was clear that it was absolutely necessary to immediately introduce republican money. Economic stability was not possible without a division of the rouble zone. We were criticized for this proposal. Legislators who strongly supported the dissolution of the rouble zone appeared to be Russian nationalists, so legislators were unhappy with this needed dissolution." The rouble zone was dissolved in 1993, but the thorny question of the Black Sea Fleet and its bases was not resolved until 1997, when the fleet was divided 50-50 between Russia and Ukraine.

"We avoided full scale catastrophe. But of course at the time public support for stabilization programs was at zero. In May 1992 [former] President Gorbachev asked me, now that we have cut the military budget and other budgets what is our level of political support? It was near zero."

As the country neared bottom it had little choice but to encourage private forces to engage in production and trade. "We had witnessed the political disintegration of the previous power. We had an extremely weak government. It did not control borders. It did not control money. There are two episodes from history that are reminiscent of this situation. In France after the Thermidorian coup of July 1794 the revolution turned to free trade to feed itself. Similarly in 1921 in Russia after the civil war Lenin introduced freedom of trade and elimination of the production tax. The Thermidorians in 1794 loved free prices. The Communists hated free trade. Both had to do the same thing. We in the 1990s loved the idea, but we also had no other choice."

A Government without a Majority

After two experiments with inflation fighting in 1992, the Russian authorities in late 1994 concluded they needed to undertake a further massive budget cut to halt price rises. They planned to cut the state budget from 10% to 4 % of GDP for 1995. "Generally it worked. In 1995 there was a rapid decline of inflation, along with a decline of interest rates. But after the election in 1995 the government had no majority. The majority was in the hands of the Communist opposition. This opposition was able to overrule the government."

The government could cut expenses, but still had obligations. "We stopped 51 laws that were unrealistic and impossible to finance. But what do you do with your obligations that are not in your budget? We had to pay pensions and salaries. We had public services that had to be carried out. It is extremely difficult to be hard on the taxpayers, especially if the government's conduct looks to be the source of the problems. So the budgeting foundation for monetary stabilization was shaky."

An Explosion of Short-Term Debt

The Russian government began 1995 with little overt debt. "The share of internal debt to GDP in January 1995 was very low, 2%, not terribly dangerous. Internal debt could rise safely." Over the next year, however, serious instabilities surfaced in the Russian system. Inflation was running 20% a year. The government met its extensive obligations by issuing short-term Treasury bonds (GKOs) at interest rates of about 30% and at one point as high as 80% per year. A tax system had been brought online, but there were very high rates of systematic tax evasion. And while the tax base of the Russian government was high compared to many developing countries, it had inherited social spending obligations from the Soviet period that were far more expensive and extensive than those of any developing country.

"As we came to the presidential election of 1996, Yeltsin's chances appeared low. There was great uncertainty, which contributed to a swift expansion of government expenses. There was a very rapid buildup of short-term internal debt, GKOs with maturity of less than 3 months." So even though Yeltsin was elected in July, the situation had become unstable.

"We needed to radically cut interest rates," Gaidar said. "Interest rates were running 30% and for part of the year much higher. This brought a huge participation of nonresidents, coming to this market, wanting to hedge their currency risks. They go to the republic central banks, and the banks become vulnerable by backing these bonds. The nonresidents need predictability. The central bank had to operate in a narrow framework according to IMF rules."

Impact of the Asian Economic Crisis

In the first part of 1997 there was a growth spurt that substantially improved the condition of the Russian economy. "It looked like the problem was going to be solved. There was a lot of enthusiasm about the Russian economy. Then came the Asian crisis, which led to a big withdrawal of funds from the market, the price of oil fell, and it became clear that Russia had no exit strategy. The interest rate goes over 60%. You print money to pay interest and you have inflation. You try to show that you cut investment, and raise taxes to show you are stable, and investors don't believe you."

International speculation began against the overvalued Russian rouble. The government tried to defend the rouble by putting a floor under its price through official purchases. The Russian Federation's central bank reserves were going down by $1 billion a day. In the world commodity slump brought on by the Asian crisis Russia's exports fell drastically as well. What to do?

Devaluation of the Rouble and the Crisis of 1998

In August 1998 the Russian government acted to devalue the rouble by 34% and to declare a 90-day moratorium on the payment of foreign debts. Within a few months the rouble had lost 80% of its value. "The government decided to stop using reserves to defend the rouble, and to restructure the GKOs. This was an extremely unpleasant solution, which brought much criticism. But these solutions did work. There was a bankruptcy of several big Russian banks, but the banking system is a small part of the Russian economy."

Gaidar saw two positive developments in the 1998 devaluation: "It eliminated the pressure of the GKOs on the economy, and the rouble ceased to be overvalued and became undervalued, which was much more stable."

The Post-Crisis Russian Economy

In Gaidar's view the 1998 devaluation of the rouble laid the basis for a period of more even development. He pointed to a decline in imports in 1999, which allowed Russian enterprises to develop domestic market niches for themselves, a strategy of import substitution. Many of the old uncompetitive Soviet enterprises had survived into the late 1990s by turning from the market, where their goods were unsellable, to barter. Some 54 to 60% of the Russian economy was on a barter basis until the devaluation of 1998, after which this dropped to 15%, an important step toward normalization.

In the question period Gaidar was asked when the Russian government would legalize a free market in land. He replied that land sales were already constitutionally mandated but specific enabling legislation still needed to be passed. "Last year a section of the civil code was instituted that legalizes private ownership of land. It also established a Land Court. But turnover of agricultural land still needs to be resolved. It is scheduled to be adopted in 2003, but may involve some compromises. There are reservations on the right of foreigners to own land."

One questioner asked how Yeltsin could have been reelected in 1992 when the country faced 2000% inflation. Gaidar's response was generous considering that Yeltsin ousted him as Prime Minister at the end of 1992 as a concession to the conservative backlash against Gaidar's "shock therapy." Gaidar in 2002 said of his former boss, "Yeltsin is a Russian institution, a revolutionary leader. His weaknesses are exaggeated in the West, his drinking. The Russian population hated the idea of going backward. In 1993 there was a referendum on whether people supported the economic reforms of 1992. In 1996 with all the disafection, people still voted for Yeltsin."

Another member of the audience asked how long it will take until Russia has a full market economy. Gaidar responded by saying that Russia has a market economy now. "But after three generations without entrepreneurial experience, without civil society which makes the market civilized, it will take some generations to fix this. Ten years is an optimistic estimate."

Why Has Russia Not Done as Well as China?

A question that elicited wide interest was why the recent Russian experience has been so different from that of China, where there has been steady and rapid economic growth for two decades.

"China," Gaidar answered, "started on quite a different level of development. In 1979 China had a GDP close to that of the Soviet Union of the late 1920s. They had a small state industrial sector and excess labor in agriculture. They were pushed to introduce market relations into their economy, and drew on freed up cheap labor from the countryside. Russia had gone much further on the socialist path. Russia lacked this large agrarian labor force that could be used in a new market sector. China is now facing what to do with the state sector, a big problem, but we had to confront this sector from the very beginning. Also, China began its market transition 12 years earlier than Russia did."

The Present and Future of the Russian Economy

Following his formal lecture Yegor Gaidar attended a lunch meeting with UCLA faculty where he continued his remarks.

The Weakness of Russian Democracy

"The essence of the Soviet system was the elimination of all forms of civil society," Gaidar said. This has posed a major challenge for creating self-motivated economic efforts. "All forms of self-defense were criminalized. All forms of commonality were eliminated. All local self-government was suppressed. These are the structures needed for localized market production."

The present government, he said, is not suppressing civil society, but these local connections are slow to regrow, which is likely to impact not only the economy but also the future of Russian politics. "Russia will be a market economy in any conceivable future. Functioning democracy is more debatable."

Kazakhstan, he pointed out, "has formal democracy but not real democracy. You need political parties, freedom of immigration, a free press. Those in power in Russia have a great deal of power to influence elections. Think of Mexico under the PRI or Japan under the Liberal Democratic Party."

There are many advocates of managed democracy in Russia today. "One argument for this view is fear of a revival of the Communist Party. But managed democracy is always corrupt."

Legal Basis for the Market Laid But Not Implemented

Despite this limitation, Gaidar felt that the basic reforms needed for a stable market system have been in place for at least five years. "The most essential decisions to be implemented were adumbrated in 1996-97. They were introduced to the Duma. But the political situation was absolutely unsuitable for implementation. The needed steps could not be pushed through the state Duma.

"The necessary legislation was sidelined by the Asian crisis. We then had a leftist government from autumn 1998. It was expected that [Yevgeny] Primakov would be the next president, so the chance of implementing the agenda of reform was close to zero." Primakov, a former foreign minister, was appointed Prime Minister by Yeltsin in the late summer of 1998 in response to collapse of the rouble.

"There were a lot of compromises in documents submitted to the Duma in 1997. We were asking for income tax, labor reform, privatization of the land, etc. It is evident that all of this is necessary for Russia, but this was a period of preparation, not of implementation."

The Election of Putin

Gaidar insisted that it had been "absolutely unexpected" for Vladimir Putin to win the presidency in March 2000. This greatly improved the situation for the reformers. "A lot of people who were around Putin were long-time members of the group of Russian economists who supported the economic reform. Putin supported a radical version of our program in 1999. It was an enormous advantage for us."

Putin and the Oligarchs

The Russian economy under Yeltsin had a reputation for being dominated at the top by a group of gangsterlike tycoons known as the oligarchs. Gaidar was asked if this situation has changed under Putin.

"In the late 1990s," Gaidar replied, "the oligarchs described themselves as the 'real government of Russia.' Putin said if he were elected he would end this oligarchy. Some of the oligarchs adjusted. Some returned their wealth. Many moved, to Israel, Spain, the South of France. Some still have ties to big business, but they no longer run the government."

The financial crisis of 1998, he said, reduced the financial wealth and political power of two of the most corrupt groups in Russia: the oligarchic tycoons and the regional governors.

Why the Russian Reformers Backed a Regressive Income Tax

In July 2000 the Russian Duma at the urging of President Putin lowered the top income tax rate from 35 percent to a flat 12 percent. Many nations, including the United States, have tax rates above 35 percent, so there was some surprise that reformers such as Yegor Gaidar supported this step, which would appear to lower taxes for the wealthiest segment of the population. Gaidar acknowledged that the new tax structure is "highly regressive."

At the beginning of the 1990s, he said, "when we had no experience with market systems, we thought we could more or less import a tax system from a developed country. We adopted a system very similar to the French system: High social taxes, progressive income tax. It combined a very high marginal tax rate, especially on wages, with many tax privileges to stimulate the economy."

But real tax behavior is defined by common experience, not by laws. "The national tax systems are a historical product. the French don't like their tax system, they hate it, but they generally comply. It is part of the general social contract that you have to pay tax. In Russia there is no such social contract."

Taxes in Russia began under the Mongol invasion in the 13th century. They were looked on as a foreign imposition, and were abolished under the Soviet system. When the French-style progressive income and profit taxes were imposed by the Yeltsin government "People did not comply. People in the lower brackets paid -- teachers, doctors. Those who should pay in the higher brackets found ways not to pay. Only the poor paid the taxes. The reason for the high regressive social tax was to cover pensions, but this did not persuade the taxpayers. Those who had to pay in the higher brackets would not pay."

This was not all bad. "The government needs to feel some pressures from the revenue side to make it reconsider expenditures." One of the expenses that the government began to cut back after the crisis of 1998 was payments for vacations, which had been an accepted benefit under the Soviet system. It also began to cut the subsidies to inefficient state enterprises, which had fueled the ubiquitous barter system.

Still, it was not viable to have a tax system that was mainly honored in the breach. A key reason to reduce taxes to an acceptable historical minimum was to halt the flow of goods being siphoned into the illegal market to avoid taxation. "We had to cut down the marginal tax rates on wages, or we could not legalize big parts of the Russian economy, it would remain a gray economy."

It turned out that the government did not face a drop in income from lowering the tax rate. The cut in the higher marginal rates was for people who were not paying their taxes anyway: "If there is a marginal tax rate that is bringing you virtually zero revenues, you can cut these rates without fear of losing income. The flat income tax was absolutely the evident solution to this problem. We took the minimal rate of the moment, 12%, and made that the flat tax rate. The minimal rate was 12% and the effective rate was 12.8%." It is reported that Russian tax revenues rose by 70 percent after this reform as people abandoned costly tax-avoidance schemes. "We expect to collect $7 billion from taxes in 2003, a huge amount of money for Russia."

New Legislation

Gaidar pointed to unfinished business of the reform effort. In particular the coming year needed to fix the pension system and settle the legality of the sale of land.

Because of inflation, periods of government insolvency, and the abrogation of former Soviet obligations, pensioners have been among the most penalized of the population. Even for those approaching retirement, Putin himself has said that no one in Russia is able to compute the value of their pension in advance. Russia is a country that has already completed its demographic transition and has a greying population and a reproduction rate that barely replaces the existing population. This makes the elderly a volatile segment of society.

"Until January 2002 the pension system remained that inherited from USSR as modified from the period of high inflation," Gaidar said. "This is now replaced by a radical new pension plan, promising an average pension of 33% of wages."

The new system has been adopted but is still in process of implementation and needs additional administrative legislation to finalize the agencies to administer it. It has three levels: a flat, basic pension of 450 roubles per month to anyone regardless of previous contribution. The second level, which is earnings related, depends on previous contributions by the pensioner's employer. It is adjusted for inflation and for the earnings ratio of the national pension fund. The third, so-called fully funded section is in effect an individual retirement account and depends on individual contributions adjusted to the rate of return on the fund's investments.

"There is a tremendous need to regulate the private ownership of land. Private ownership of land is legal, you can own the land. If you have a factory and part of the land it is on is in the hands of your municipality, you have a right to buy the land. This is a more or less normal situation. The sticking point in the law on the land court is over foreigners' right to own the land. This is purely ideological. There is a limitation for foreigners in the frontier regions particularly."

Curbing the Media

Daniel Treisman of the Political Science Department asked Yegor Gaidar if the seizure of NTV, the only independent national television station, was an example of an orientation by Putin to managed democracy.

The offices of NTV were forcibly occupied by the police in April 2001 in a hostile takeover by the state-controlled gas monopoly Gazprom. This was allegedly because of unpaid debts by NTV owner Vladimir Gusinsky. With NTV's collapse, all three national news-oriented channels, covering 99% of viewers, are under state control.

Gaidar was noncommittal on this point. "I don't know the answer. These were not independent media. All these media were financed by the state. Look at the new NTV, it is sound." Gaidar was refering here to the reorganized NTV, which went back on the air under state ownership shortly after the takeover. Its new managing director, Boris Jordan, has insisted that the content of the station remains independent of the government, but its ratings have been falling in the year since the takeover.

Current Economic Performance

Russia's gross domestic product grew by 5.4 percent in 1999, 9 percent in 2000, and 5 percent in 2001. It is expected to drop to a 3-4% increase between now and 2005. "Reserves are growing by 10 billion per year," Gaidar said, while acknowledging that "economic growth is going down." He explained the slowdown as due to an inevitable appreciation of the rouble, and an unfavorable world market. When asked why Russian goods had not penetrated the American market to the degree that Chinese goods have done, Gaidar replied that Russia was moving toward a knowledge economy and did not have the comparative advantage in labor costs that China had. "I would hope that when Russia penetrates the American market it will be with computer software, not with toys."

Published: Wednesday, June 19, 2002