Market Failure IV: Russia

The fall of the Soviet Union was a tremendous opportunity. That was squandered when the advice of free market zealots overrode rational transition schemes. Ronald Reagan's grandstanding aside, most historians will say that the West won on the basis of economic might. The democratic mixed economy of the United States produced enormous prosperity for its citizens, replicated in Western Europe. The Soviet Union and that part of Europe under Soviet-style command economies fell further and further behind. Finally Russia acceded to the inevitable.

As we will see, under Western sponsored "shock therapy" Russia was not transformed or invigorated, but brought to its knees economically. Today, largely on the basis of its oil resource, that nation is rising from decline. But the Russia of Vladimir Putin bears more resemblance to the bureaucratic dictatorship of the Soviet era than it does to a European-style democratic mixed economy.

Now. What happened? Why is this market failure IV? Following we offer a very quick description, a skimming of the events taken largely from Stiglitz excellent book Globalization and Its Discontents, the 2003 version.

The debate between gradualists and the free market fundamentalists in the IMF and US Treasury was won by the latter. Their prescription of wholesale liberalization of the economy was accepted by the Russians.

The first mistakes occurred almost immediately upon the decision to institute the shock therapy. Most prices were freed overnight in 1992. Since many prices had been kept artificially low under the communist regime, freeing them – or liberalizing – set in motion an inflation, a hyperinflation of double digits per month, that wiped out savings and moved price stability to the top of the agenda.

The second round of shock therapy thus began – raising interest rates to stem price increases.

The third round of shock therapy was rapid privatization.

When the smoke cleared, a few dozen oligarchs were in control of former state-owned industries. A more broad-based ownership was frustrated by the inflation, which wiped out the savings of the broad population and prevented them from becoming stakeholders in the new economy.

Between 1990 and 1998, Russian industrial production fell 42.9 percent. GDP fell 45 percent. This was nearly twice the damage experienced by the nation's economy during World War II.

The oligarchs got wealthy not by developing industry, but by buying oil at its still restricted prices and selling it overseas. They exploited the newly opened capital markets – a fourth element of shock therapy – to send a flood of money out of the country, quite the opposite of the intention to draw outside capital in.

The IMF kept promising recovery was just around the corner. In 1997 a combination of high interest rates, a collapse in oil prices and insistent borrowing – at IMF direction – to prop up the ruble, eroded the base of the economy completely, and it collapsed.

As Stiglitz says, page 146

An overvalued exchange rate – combined with the other macroeconmic policies foisted on the country by the IMF – had crushed the economy.

Although unemployment was disguised, it was no less traumatic. Workers were kept on payrolls; there was little production. As Stiglitz says,

While workers only pretended to work, the firms only pretended to pay. Wage payments fell into massive arrears, and when workers were paid it was often with bartered goods rather than rubles.

In July 1997 a "rescue" quote unquote was organized by the IMF with participation by the World Bank and was primarily intended to keep the value of the ruble high. Tens of billions of dollars in loans were organized to support the exchange rate.

The rescue failed. An inevitable devaluation did not lead to the doomsday predictions promised by the IMF. But the debt was in place. The oligarchs and Western bankers took what they could.

This is the history, or the froth of the history. What was the root of the failure?

The shock therapy. While markets work, they only work in the context of strong government institutions and mitigation of excesses by social programs. Western societies have hundreds of years of institutional development. Regulatory agencies, courts to enforce contracts, well-developed supply chains and intermediate markets, controls against monopoly exploitation and patent corruption. Russia did not have these. The Soviet economy, in fact, had relied on back alley arrangements to circumvent the official red tape, and was thus practiced in corruption.

Free market fundamentalists believed that the magic of the market itself would organize the society. No less blind than religious zealots, they pushed an idealized liberalization ahead of institutional development and oversight. Most notably, democracy itself was left to follow the market rather than lead it.