The Economic Reforms: Results and Prospects in Russia

CIAO DATE: 07/01

The Economic Reforms: Results and Prospects in Russia

Dr. Marshall Goldman _*

March 1, 1995

Speaking after Murray Feshbach may seem anticlimactic in some sense. I know it was very depressing for a lot of people, but let me warn you that it's not going to be much more optimistic this morning. In fact, I was introduced at a speaking engagement in Washington as the Dr. Kevorkian of Russian studies. And you heard the title of my books. There was one other that I probably should mention, USSR in Crisis: The Failure of an Economic System. So now with all this gloom and doom that I'm associated with I feel a little nervous coming to a group, particularly in the morning. In the evening the day is over, you can be depressed. But it's not such a nice thing to begin the day that way.

Having come out with this book which appeared in October, I was a little nervous because in the summer, the late summer in particular, in August, there began to be some positive signs about what was happening in Russia. And here's this book which is not a neutral statement– Lost Opportunity: Why Economic Reforms in Russia Have Not Worked. That's not ambiguous, I'm out there. And yet if you look at what was going on inside Russia, goods begin to reappear in the stores. Remember January 1992, the shelves were empty, you saw long lines of people. You certainly have to remember those images of very poor people, there was just nothing available for them to buy. And now suddenly the goods are everywhere! I remember having a conversation with a young woman in 1992. She was telling me she'd never seen cheese in her lifetime. Now, there's not only all kinds of varieties of cheese, but bananas. That was something that was only a fictional subject as far as she was concerned. And, in Russia today, or at least in 1993, more Mercedes 500 and 600 models were sold than were sold throughout the rest of Western Europe. Some of them were stolen, but that's neither here nor there. Also in terms of privatization, you heard last night, those of you who were here, that privatization has indeed become widespread, from almost 0% to 70% of Russian industry. Russian business right now is in the hands of private individuals as opposed to the state. For the foreign community there's also a very dynamic change, dramatic change. Some western businesses have done very well, exceptionally well. McDonald's has now three stores, three restaurants in operation, the most desirable office building, they're in the process of building three or four more stores. The first store, the base of their operation, serves 20-30,000 customers a day, not a year, a day. Those of you who have been there know what's happening. Kodak has opened up photofinishing laboratories throughout the country. Mars Bars, Mars Corporation which is a privately held firm, sells hundreds of millions of dollars worth of product: chocolate, Uncle Ben's Rice, dog food, it's one of their largest markets in the world now. Polaroid has discovered that Russia is it's fourth largest market--United States, Japan, Germany, and then Russia. Gillette sells more razor blades in Russia than in any place else but the United States and India. So this is a dynamic change. All has happened within the last two or three years, and indeed since this past summer, things are going remarkably well.

If you travel around the suburbs of the cities, the outskirts, you find the construction program is very dynamic. Under Gorbachev the rule that you could only build a one story house was abolished, so people began to build not just wooden dachas that we're used to seeing out in the countryside, but concrete homes. Not only homes, villas. And since this new wealth of this new class is beginning to be flaunted, they're not really villas. They're a kind of grotesque monument to glory and to greed, reminding some of us of what New York was like on Fifth Avenue in the nineteenth century. When you've got it, you have to flaunt it to tell everybody that you have it! So you get turrets and moats and all these kinds of things--a very dynamic change.

From the economist's point of view, inflation was being brought down. In August, it was under five percent. It was five percent a month, but still a very dynamic change from what was there before, and foreign investors were flocking in with money on the order of 500-600 million dollars a month. This was called an emerging market. Now, granted it was a peculiar emerging market, but it was an emerging market! Some say, indeed, you want to get in early, because prices had risen threefold; if you wanted to sell, that was another problem. Russia was described as an emerging market from which it was impossible to emerge in an emergency, but otherwise on the way up, it was certainly a very impressive kind of thing. And then articles began to appear, including one by a friend of mine, Anders Aslund, that appeared in Foreign Affairs in the summer, which said that Russia now had virtually become a predictable country.

Now, I've got this book coming out. This is August, it's already committed type. I reassured my publishers that it's all right, the title's going to be fine– Lost Opportunity: Why Economic Reforms in Russia Don't Work. But it looks like the reforms are working! And I'm worried the book is going to be remaindered before it even is sent from the printing house, which is not a very comforting thought for any author. Now, I shouldn't say this, but you can understand, given what I've just said, how relieved I was when the ruble collapsed in October. It lost 25% of its value in one day. Indeed from June to October 11th, it lost 50% of its value. It recovered on October 12th, but now of course, it's back down again to below where it was before. It was 2000 rubles to the dollar in June 1994, on October 11 it was 4000 rubles to the dollar, now it's basically 4500. And I should also not confess this, because this is a more serious problem. The events in Chechnya suggest that politically the society also is in a state of uncertainty and a considerable amount of chaos. What I argue in the book, and what I'm going to argue now, is that this is not an anomaly. There are some that say, well, the Chechen thing is an anomaly, just as the shelling of the White House in October 1993 was an anomaly, this was something which would pass. But in my mind it's not something that's going to pass. I don't want to say that you cannot escape from your history. I wouldn't want to argue that at all, but I would argue that for a society which has never experienced prolonged periods of democracy, even short periods of democracy, moving to a democratic system is not an easy task. More than that, because of the heterogeneity of the society, if it weren't the Chechens, it would be somebody else. There are over a hundred different ethnic groups, many of which are determined to declare their independence, many of which were brought into the Tsarist Empire-- not the Soviet Empire but the Tsarist Empire - against their will. This means that this is a society that is being held together with force even now. Given the opportunity, many are going to move themselves out.

So, what I want to suggest then is that the preconditions for the reform are not very good, are not very felicitous to say the least. When you introduce a series of reforms, beginning with the Gorbachev reform, but focusing most carefully now on the Yeltsin reforms, which are misconceived and misguided, you're going to make it worse. What I want to talk about then, today, are the reasons why I think the reforms are misguided and misconceived, misconstrued, and misapplied, and why this is going to make ultimate reforms so difficult. So I'll talk first of all about the source of the problem–what makes this society so difficult to reform, and then I will end with a discussion of why I think that misguided reforms are not costless. Misguided reforms are costly, and they bear a cost, which creates malignancies; a cancerous form of activity on the society that is going to make future reform all the more difficult. In other words, if you screw it up in the beginning, it's going to make it all the more difficult to move ahead in the future, and it's something you can't put aside.

Okay, what is the source of the problem? That's what I want to focus most of my attention on. The source of the problem was that, in my mind, shock therapy, which was the main structure of the reforms that were introduced, was wrong, was misguided. It was the wrong strategy for the wrong time and the wrong place. First of all, what is shock therapy? I don't want to give you a long lecture on basic economics, but if I can do it in a minute or two I'm going to try. Shock therapy has worked very well in other parts of the world, when the conditions were right for it. What is shock therapy? Shock therapy is an attempt, just like in mental treatment, to put into order something that has become dysfunctional. Shock therapy is applied to the human, when your brain is off a little bit. So you're given an electric shock. It's painful; the economic reform is painful when you first apply it, but if you hold on for a while and can endure, then everything is going to be back to normal. It's like when your P.C., your word processor, is out of order, you give it a kick and then it starts operating normally. It's the same kind of thing with an economy.

How can an economy become dysfunctional? Well, for political reasons, both in Latin America but also and in the Communist world, it was decided that it would be better political strategy to make sure that there was no inflation. One of the glories of Communism, from the point of view of the propagandist but even of Soviet leaders of that time, was that they could say: "look what a superior society the Soviet Union is...We don't have inflation. You in the capitalist West are bound by inflation. Your prices are constantly going up. We're going to make sure in a Communist utopia, there will be no increase in prices." So bread prices, for example, were not increased after 1955. They stayed constant to almost 1990. Until then they would say, "You're robbing your proletariat pushing your prices up. In the Soviet Union, we don't have anything like that."

That makes good political sense, as long as costs don't go up. But costs were rising. So what happens when costs start to rise? How do you hold prices down? You have to subsidize the price of bread. Well, that's okay within limits, except you begin to subsidize the price of bread. People begin to consume bread who wouldn't otherwise do it and the society really gets all mixed up. How do you keep the cost of bread down? I just said, you give subsidies. Where do the subsidies come from? They come from the government budget, but that means you have to increase budget expenditures. But if you increase budget expenditures, that means after a while you begin to run the risk of a budget deficit. If you have a budget deficit, how do you finance it? You finance it with the printing of money. What happens when you print money? You have inflation. That's macro economics in thirty seconds. What happens when you have inflation? Costs go up even more, you've got to increase your subsidies; you're on a merry-go-round and you're never going to get off.

The other thing that happens, of course, is that the normal supply and demand curve interaction is distorted. This is microeconomics in thirty seconds. Costs are held down, that means more people will want to buy bread. They are lower in the demand curve than they should be. But supplies are also lower in the supply curve. Not enough is being produced, and you have shortages. You have queues. So, what happens? They misuse bread. But how can you misuse bread? Bread's such a basic product. Well, what happened is that because the price of bread is so low, the peasants, along with everyone else, were given mixed signals, the wrong kind of signals. Imagine you're a peasant in Russia; and peasants are always wily. Imagine you're a wily peasant. Here you are with a situation where the cost of growing grain has gone up. Therefore, you sell your grain to the state at a high price. But now, you've got livestock. How do you feed the livestock? You take that grain, that you can sell to the state at a high price. But then how to do you feed the livestock? Would a wily peasant feed them? What would you do if you were wily peasants? Well, I guess nobody here's a wily peasant. But there's an alternative to grain. What's the alternative? To feed them bread! Because the bread price is cheap. Feed the livestock cheap bread, and sell the grain at a high price. So, fifteen percent of the bread being baked in Russia was being fed to the livestock. That means enormous misallocations. One of my friends went into a bakery, (you'd go into the bakeries, and see signs, ‘guard bread, our most precious product') and once he saw this sign that said "don't feed bread to the pigs." He came out and said, "Who would feed bread to the pigs?" And I said, "All the wily peasants are feeding bread to the pigs!" That makes good sense. One of my other good friends, Seymour Goodman, who's a specialist on Soviet computers, arranged for an American firm to buy Russia's largest, most sophisticated computer; not for its computing power. What they wanted to do was melt it down because it was made of precious metals that were more valuable as raw material than as a computer. This reflects what happens when resources are misallocated.

So you introduce shock therapy. What is shock therapy? Stop the printing of money, let prices rise. So the microeconomics begins to work, the prices go up. What happens, you go up the demand curve, fewer people are buying bread, so the lines diminish. You go up the supply curve, higher prices. Higher prices, higher profits, more production, you begin to get stabilization, you get a market clearing process. And at the same time you can stop paying the subsidies, so budget expenditures drop, and there is no budget deficit. No budget deficit, no printing of money. You begin to stabilize society. You've kicked the computer, and it begins to work now in a very rational kind of way. And it worked beautifully throughout Latin America. It's painful at first, people do suffer. They have to pay more. People are fired, because they're producing things that are no longer needed, and it hurts. But at the same time, the society kicks in and usually experiences relatively good growth assuming there's no political upheaval. More importantly for the reformers in Russia, they looked around and said, "Hey! that's exactly what they did in Poland." In January 1990, the Poles introduced Shock Therapy, and it worked beautifully. It was painful at first, the first year, economic growth dropped, but gradually things began to kick in, and last year Poland showed the highest economic growth of any society in Europe. Not just Eastern Europe, but ALL of Europe. Now, there are political problems. There's still unemployment in Poland, and you can't produce Utopia in a few days, but basically over three or four years time, they've done remarkably well.

And Poland's a Communist country, and we're a communist country in Russia. If it works in Poland it certainly should work for us, and look how quickly it brought results. And so it was decided, on January 2, 1992, to introduce shock therapy in Russia as well. The problem was that the economists who were involved in this had a certain amount of hubris that was misplaced. Their feeling was, "If you've seen one economy, you've seen them all." Both Russian economists and the economic reformers from the West said this. The trouble is, that they did not appreciate that Russia was not Poland, much less Bolivia or some of the other countries in Latin America. Why was it different? They had very important institutional differences. First, in Poland, 80% of the farms had never been collectivized. In Russia, 100% were, and they didn't appreciate that. The second thing is that in Poland you always had a private service sector, a private manufacturing sector even, not large, maybe 15% of the total economy, but there was something there. This is important because when those prices go up, you've got to have somebody who's going to be responsive, who's going to be elastic, who's going to increase production. It's going to be like a sponge, it's going to expand. In Russia, if 100% of the farms are collectivized, the farmers aren't going to be responsive. In Poland it even took the private peasants a while to realize this was for real. But after a few months they began to produce more, responding to those higher prices going up the supply curve. In Russia they didn't go up the supply curve. What happened was they went up the demand curve, and that's why the goods began to reappear in the stores. But I will tell you now, and repeat again in a few seconds, what happened in Russia was that production dropped.

Okay, now that's an important difference. There were three other differences between Russia and others that had experience shock therapy. The first is that when you're going to make this transformation you need somebody with a lot of experience and a lot of administrative talent who's able to respond this way. In Russia there was really nobody, who had experienced living in a market economy. But they picked someone who was really good, a man by the name of Yegor Gaidar. But he was only thirty five years old. I have nothing against people who are thirty five years old, but this man had no administrative experience. The only administrative experience Gaidar had, although he was honest, a quick learner, and a very able person, was being a department chairman in a research institute. Now, I have nothing against department chairmen. Some of my best friends have been a department chairman. I've been a department chairman. It's something that as academics we would want to aspire to. But let me tell you that is not the only thing you'd want on somebody's resume who is about to take over the American economy, much less the Russian economy which is about to go through this massive transformation. That simply wasn't enough experience. I think what Gaidar thought, when he was preparing the proposals that Yeltsin ultimately accepted and introduced, that he would end up more or less like a chairman of the Council of Economic Advisors - a group that, after all, we have in the United States too. Being the Chairman of the Council of Economic Advisors is a nice thing for an economist. "On the one hand you can do this, but on the other hand you can't do this." Economists are very good when it comes to using two hands. The difficulty was, however, that Yeltsin immediately appointed Gaidar as Minister of Finance, which means you've immediately got one hand tied behind your back, because you have to act. You can't say, "Well on the one hand, and on the other hand." You've got to do something really concrete. Yeltsin made Gaidar not only Minister of Finance, but he also appointed him to Deputy Prime Minister, and then he made him Acting Prime Minister. And here was Gaidar now, with really no experience, not having lived in a market economy, no administrative background at all, suddenly in charge of this whole society. Such jobs are difficult enough in a society not going through change, but here in this upheaval, this tumult if you will, Russia was about to go through very radical changes.

I saw Gaidar at this juncture in Moscow, and I really had the feeling the poor guy was beyond his depth. His eyes were bulging, and each time, he had to deal with new responsibilities and new problems. And remember this was now 1992, in the middle of our election period. He reminded me ever so much of Ross Perot's running mate, Admiral James Stockdale. I swear, Gaidar was saying to himself, "Who am I?" "What am I doing here?"

But there were two other problems that I want to focus on, that make reform, any reform, very difficult. The first has to do with the kind of institutional difference that I had mentioned when I talked about the collective farms. And the second has to do with the wrong kind of spirit--the mentality and the approach toward the market. Let me begin first with the question of the institutions. Russia, having evolved from the Soviet Union, lacked the market compatible institutions that were necessary to bring about the transformation of the sort that you would have seen in Bolivia. And what I want to argue - very strongly argue - is that shock therapy will not work when those institutions aren't there.

What do I mean by that? These institutions are like the private farms but include the whole market infrastructure. They were destroyed under the Soviet leadership. They were destroyed because Soviet leaders sincerely believed that the central planning system and state ownership, were superior to the market system. In the process of moving to a Communist society, they wanted to do everything they could, first of all, to stress and promote what they saw as their advantageous opportunities, and, second of all, to make sure that the system never reverted back to a market basis, to a capitalist base. Now, given what we know, how could anyone in their right mind affirm and assert that a centrally planned system is superior to a market system? Given the fact that they failed so badly , it seems hard to understand. But I would suggest, I would warn, that most of you have had similar thoughts, saying "My god, the market system is wasteful." What kind of waste? Well, have you ever driven down the street, come to an intersection and noticed that there were four gas stations on the corner? What do you need four gas stations for? What you need is one large one. And the Soviet leadership in effect said what the Soviet Union needs is one very large gas station, because that will give them economies of scale, and will eliminate the duplication that comes from wasteful competition. When someone mentions economies of scale, most economists have palpitations of the heart. Because it means they are going to be able to build very large factories, and the Russians prided themselves on Gigantomania. The Soviet Union had the largest factories in the world. They were also monopolies. So they didn't have "wasteful" competition. And economies of scale mean that they should have been able to produce at a much lower cost than others would be able to do. So, over 60% of the Russian factories had monopolies in producing machinery. 60% of Russian factories had a work force of a thousand workers or more. Some of them were 125,000 workers. In this country, 26% of our factories had a work force of over a thousand or more. And we say they were too large. So here were the Russians building these monstrous things.

I was at a panel discussion once with one of the vice-presidents from Pepsi-Cola, and I mentioned this business about wasteful competition. He got very agitated. After the discussion, I said, "What did I say that got you so agitated?" And he said he began to think of what a wonderful world this would be if there were no Coca-Cola! That is just the kind of thing that the Soviets wanted. They expected they would be able to produce at such a cheap rate that they would be able to out-produce everyone. So, they had economies of scale.

It was not only that they purposely build these large factories, sometimes dominating cities of a million or more, but they also destroyed any traces of the old system. Gone were wholesaling, retailing - private retailing and the infrastructure that provides all the detailed kinds of operations, commercial code, bankruptcy. They did away with lawyers (I don't mean to say it all has to be bad), but basically any elements of that old system were done away with. Now, of course, in fact they ended up with no gas stations on any corner, but the theory was a terrific one.

But what happens when you begin to convert that system back to a market? You've got industrial dinosaurs, you've got these large factories that are not responsive, and you don't have anything underneath that's going to operate. You can chop down a forest very easily. You just bring in saws, bulldozers and chop it down. In the same way you can destroy a market very easily, just shoot everybody. Shoot all the bourgeoises owners. But if you want to recreate, if you want to plant a forest, you can't do it just by planting ten trees. You need an underbrush, you need birds and bees. If you want to create a market, it's not enough to open up ten stores and say you've got a market. You've got to bring back the lawyers. You've got to bring back the accountants. You've got to bring back the commercial code. You've got to set up bankruptcy procedures. You've got to have wholesaling infrastructure. You have to have stock markets, commodity markets, and those things simply were absent in Russia when it began the process.

Yet goods began to reappear in the shops. But to repeat, that was only because customers were forced up the demand curve, not because manufacturers began to produce more. Indeed production dropped thirty percent the first year, because the monopolists were doing what monopolists do very well, raise prices, cut production. That's the institutional shortcoming. That is very important in my mind, and those institutions will not be duplicated in just a few years.

The second difference was the difference in spirit and mentality. To reinforce the institutional differences, the Soviet leadership wanted to make sure people didn't think positive thoughts about private trade. So they introduced the notion of economic crimes. Those charged with economic crimes were those who were caught buying, selling or manufacturing privately things that they didn't produce. You weren't allowed to do this--it was all supposed to be done within the state sector. Anyone guilty of an economic crime was subject to life imprisonment, or death. Being faced with the thought that you might be shot for producing some handicraft work turned out to be deterrent.

In addition of course, there was the problem of Russian culture. Again, this is a very tricky thing, and it's a stereotype, but there is something there that I think is worth considering. Russian peasants were serfs until 1861. This you know from your Russian history. And then when they were emancipated, they were not emancipated in a way that said, go off and do whatever you want. Basically they were emancipated with the idea that they had to stay in the countryside in the obshchina, the communal organization, the mir, and redeem themselves from the landlords. And so they were stuck there. It was only in 1906-1907 with the Stolypin reforms that the peasants were encouraged to set up their own farms. In the mir, the obshchina, the land they had was divided up every few years. It was in strips, and you were never allowed to put any investment into it because it was just going to be taken away from you, so why would anybody bother? It was only in that short period, from 1906-1907 to 1927 when collectivization began again, that there was any effort to create private property, private farming. So they had only that twenty year window of that kind of experience. The Stolypin reforms were followed by collective farms and economic crimes. So both the culture and the purposeful efforts of the Soviet leadership deterred, and criticized private activity.

A genie comes and says, "I have three wishes, what would you like?" The first person the genie sees is a Frenchman, and the Frenchman says, "Oh, I'd like my chateau, my mistresses, and my vineyard." "Okay, you've got it." The next person is an American. "What would you like?" "Well, I'd like my VCR, and my laptop computer, and my handgun." "Okay, you're all set." The third person is a Russian. "What would you like?" "Well, my neighbor has a goat. I don't have a goat. Kill my neighbor's goat." With that kind of approach, it's very difficult to get people to go off and create their own businesses. Now that can change. I don't want to say it can't change. Indeed we see among the younger generation in particular a responsiveness that is quite encouraging. But for the older generation, and the middle generation, it's not so easy. So you've got a combination: institutional differences that are very distinct and militate against any transformation to a market system (they simply aren't capable of dealing with it) and a mental attitude that, of course, is also going to be very difficult.

**Now, what should they have done? Given what I've just said, the implication is that almost any reform they would have tried would have had difficulty. That was because those institutions cannot be transformed overnight; it's going to take decades. What I would have done however–but again, it doesn't say that it would have been an overnight success--I would have looked more to China and even to Hungary, because they did it gradually. If you want, this is a gradualist approach as opposed to shock therapy. The shock therapists, Jeff Sachs among others, say, "You don't, if you want to be successful anyway, leap across an abyss in two leaps. It's not very good policy to follow. You've got to do it all at once, you need to do shock therapy all at once." The Chinese say, however, "You cross a stream searching for a pebble at a time, a stone at a time. And you do it gradually." And what did the Chinese do? The first thing they did is they transformed agriculture. Whether he had a conscious policy or not, Deng Xiaoping allowed this when he took over in December 1978. And gradually, by 1982 there was a system of private farming. From zero. They also allowed the creation of private businesses, private trade, as it were. Private manufacturing. Today in China, 55% of what's produced industrially is produced in the township sector, the non-central state sector. These factories may not be all privately held, but it comes very close to that. They didn't focus on privatization. They focused on a kind of green field creation of brand new businesses, gradually building up that way. In this way they recreated the infrastructure that they needed.

As a consequence, now there are very different attitudes about how to get rich in Russia compared to how to get rich in China, or even Hungary. If you want to get rich in China or Hungary, the way you do it is you start gradually. You build up wealth, either beginning in agriculture, or in services, or in manufacturing. Now, there are other ways of getting wealthy in China, particularly having guanxi, or having connections, and friends. But the main thing is, and people accept the idea, very often you have to work, and in sweatshop conditions. But the main route is to do it through manufacturing. In contrast, how do you get rich today in Russia? Very few Russians are considering getting rich by going through the process of manufacturing. You get rich today in Russia by stealing and by manipulating. I'm going to talk more about that in a second. The quickest way is to take public goods and convert them into your own. An enclosure movement of the sorts would in effect say, "Central Park, it's mine." In England in the 16th and 17th centuries, you had an enclosure movement where people took over the commons. Similarly, in the case of Russia, the new rich Russians are basically stealing the public treasury; gold, real estate, factories, other kinds of assets.

The consequence of all this has been, at least until recently, a drop in the GNP. You heard last night that maybe there's a turn around this year, or at least they're holding their own. But this is now four to five, six years into the process. And you also had wild inflation. In 1992, the first year of shock therapy, prices went up twenty-six fold. That basically meant inflation wiped out the savings of anyone who had any rubles. Complete devastation took place.

It's hard to measure exactly what's taking place now because those in the private sector don't want to report what they are producing, because if they do, they will be taxed. Before, we had to recalculate the economic growth rates the Russians published, we had to diminish them, discount them. Now we have to boost them up a little bit, because we don't know if the statistics are capturing all the activity that is going on in the private sector. But even with the growth we know that the society certainly is producing less in some very important industries, including the raw materials industry.

But now remember, I said some things have turned around. Inflation in August was down to 4% a month, production seemed to be going up in some parts of the late summer, early fall. What explains that? How can I explain the fact that these things are taking place? The positive things that I mentioned at the beginning of the talk. Well, I would argue that many of them were offset by institutional deformities, and I use that word intentionally, and the malignancies that I mentioned earlier. Let me talk about these briefly.

What kind of malignancies? What kind of problems? Why was it that inflation dropped? Well, basically inflation dropped because the government and factories stopped paying their bills. If you don't pay your bills, then you have less spending power, and after a while, things begin to diminish. What do you mean, the government was not paying its bills? You may remember having read that because of budget cutbacks intended to reduce inflation the electric utilities were not being paid and so the plant that serviced the headquarters of the nuclear missile command turned off its electricity. And so here was the command headquarters of this nuclear base without electricity. They'd also turned off the electricity at several submarine stations. Indeed maneuvers, flying time, are held to maybe a tenth of what it should be throughout the country. It's estimated that inter-factory debt, exceeds a hundred and twenty TRILLION rubles. Now, a trillion rubles isn't what it used to be, but still, that's an enormous amount. That includes four trillion rubles in unpaid wages. People were not being paid wages for three, four, five months at a time. Now if you're not being paid wages while all this inflation is going on, it can be difficult. I asked one of my Russian friends, "How do you get along when your wages are in arrears for months, and when you do get them, they're worth twenty to thirty percent less than what you had before?" He said, "Well, it's not easy." Well, he didn't have to tell me that, I understood. Usually they have three or four jobs, they have a garden, but it does create enormous trauma. One Russian economist estimated that if all wages were paid when due, that would add another twenty percent to inflation, because people would have more spending capacity.

We had a visit in September from one of Yeltsin's advisors. He was very proud of the fact that August 1994 inflation had been brought down to under 5%. He went on to boast that, "If we wanted to, we could bring inflation down to zero." As an economist that fascinated me, because we have a way to go in this country too. I said, "Well, how would you do that?" He said, "Well, we just wouldn't pay any wages at all." Now, the only trouble is that he didn't smile when he said this. For him, this was a legitimate policy prescription. It turns out of course, that Chernomyrdin, the Prime Minister, did inject another slug of credit in early summer. By the time that slug of credit worked its way through inflation started going up again, and so in January 1995 it was 19%.

What about privatization? Privatization is something that everyone seems to be proud of. In my mind, however, that is a malignancy, that indeed is creating a backlash. I was giving a talk to a bunch of Russian generals, in September, and I mentioned privatization, which I took at that point to be a rather positive sign. The Lt. General in charge of the delegation stood up at the end of my talk and was just burning with anger. He said you talk about that as a positive achievement –that's not privatization, that's managerial looting. He said, people are going out and stealing the assets, taking things that were in the public domain and suddenly becoming rich overnight. They're taking over the party assets. Where did all the gold go? Remember how we were talking in 1991 about how Russia should have no problem making its currency convertible because it could simply use the gold? As the world's second largest producer of gold, it had abundant stocks of gold in the treasury which it could use to back up its currency. Where did it go? It all left the country, put in the private accounts of party leaders in England and in Switzerland--it all disappeared. What happened to the factories? The factory managers basically became the owners. It was supposed to be for the factory workers, but it ended up with the factory managers. What happened to the oil fields? They became the private domain of individuals. There was an article in the Financial Times about the head of LukOil, a new company that was formed two or three years ago. This young man, who's in his thirties, started out with a net worth of zero in 1991. Now he has a net worth of 2.4 billion dollars. Just simply, "It's mine....I'm the ONE who owns this." Then contrast this against the fact that all savings were destroyed in 1992 by inflation. You can see indeed why there is such anger. Why aren't people paying their bills? Because the minute they get any money, they convert the rubles into dollars and send the dollars outside the country. You have a capital flight problem of a billion dollars a month. It's estimated maybe 50-100 billion dollars has fled the country. It's gone to Switzerland, it's gone to England, it's gone to Cyprus, it's come to the United States. I have a student at Wellesley from Russia. I asked if she would come in and see me. She said, "I can't on Thursday morning, I'm busy, I'm going to see my broker." Anyway, it's that kind of thing that is happening, and that's why you have a man who is appointed Minister of Privatization in late 1994 who announces, "My goal is to reintroduce nationalization. I want to nationalize industries. I want to take them back from these people." He wants to take them back not only from foreigners, but also from Russian nomenclatura.

But the worst malignancy is the Mafia. And I want to spend just a little more time on the Mafia. According to a report that was prepared in January 1994 for Yeltsin, 70-80% of all private banking and business activity is controlled by the Mafia. Nothing of that magnitude has ever occurred in any other country, including Italy and Sicily. Because they tried to cross the Mafia, thirty bankers, six hundred business-men were shot last year. Now they're going after foreigners. Estee Lauder opened up a store on Gorki Street in 1989. In 1991 the manager came in and said, "We're taking over the store, it's privatization." But it's really the Mafia. Those of you who've been in Moscow recently know there's a battle going on over the Slavyanskaya Radisson Hotel--the Mafia has taken it over. LensCrafter opened up a store in St. Petersburg. The Manager was approached by a group saying he needed protection. He said "I don't need protection," and he was shot. Some American firms are going home. The Russian Mafia, it's not just Russian of course, it's all the different ethnic groups, including particularly the Chechens, are taking over the banks. The banks why? In the old days when I was a kid we were told, like Willy Sutton, you want to rob the banks because that's where the money is. Well today, the banks are a large target not because that's where the money is, but because that's where the records are. The Mafia can find out who has the money, and who they should go after.

And in this same way they're going out after investors. Transworld Metals, a British firm, bought what they thought was a twenty percent share in an aluminum smelter in Krasnoyarsk for ten million dollars. They go to attend the directors meeting, only to discover there's no record of their purchase. It's just simply disappeared. Kameneft, which is one of these new oil companies, has been selling stock to the public, taking the proceeds. In May 1994, they declared a three to two stock dividend, which basically reduced the equity claims of each share of stock by one third. They only announced it in December, and it was only good for people who owned stock in May. As a result people were buying stock that had been watered down by one third of what it had been before. If you look in today's Wall Street Journal, it's now announced that Russian authorities are trying to force Kameneft to compensate those who had been deceived. But the whole point is that you go through these convolutions.

The worst thing, in my mind, is not just that this is going on, but that it crimps healthy development. What is happening now is that the number of farmers opening up new farms is actually lower than the number who are leaving private farming in Russia. What happens is that when they're finally able to produce a crop, they find there's no place they can sell it. The Mafia won't let them come into the market. What is happening therefore is that the Mafia is crimping healthy reform. The mayor of Moscow, who is very closely associated with this kind of thing, has decreed that half the kiosks that have opened up in Moscow should be closed down. He insisted that the kiosks were unsightly. It also happens, of course, that the Mafia has difficulty maintaining its control if there are too many sellers. In effect the kiosks serve to break up the monopoly.

From my point of view, one of the bad things about the Mafia is that contract killing is so cheap. As any economist knows, if is were higher, there wouldn't be so much demand for it. If it's only a thousand dollars, it becomes easy to kill somebody. It turns out that I'm having my own difficulties with the Mafia. I wrote an article in August in which I said that one of the banks was in cahoots with the mayor of Moscow. The mayor of Moscow had ordered that all payments to the city be made to the bank, and that this was unfortunate because the bank was widely rumored to be under the control of the Mafia. The president of the bank didn't like that and threatened a lawsuit unless I made a retraction, which I haven't done so far. I am prepared to retract. It turns out it's not the only bank, it's one of six banks, that received city payments, but it's the lead bank I'm perfectly prepared to apologize for that. My wife says I should apologize for everything!

This kind of malignancy inevitably affects any kind of development in the future. Let me also say something about the war in Chechnya. In my mind, it's a no-win situation. The Russians should have never gotten into it. It brings back memories of the 19th century, of Lermontov. The fighting will eventually turn into a guerrilla war, a partisan war and also affect some Russian cities. But from the point of view of the economist, if the final hammer had not been made to the economic reforms before, this was it. Because the war, as a minimum, is going to cost 1% of the GNP, or at least that's what Chubais, the number three man in the government said. And it's probably going to be more than that. It's going to drag on, and it's inhibiting foreigners, it's inhibiting people inside the country, and it hurts investors. The ruble, as I said, has continued to fall, it's lost 30% of its value since the war started. The stock market has fallen. Those investors who were doing so well at the beginning of the year have lost most, if not all of their investment. Overall the situation is bad. The International Monetary Fund is now in Russia deciding whether or not they should give them an additional loan. It seems to me it's fantasy for the IMF to give them an additional loan, because it's simply going to finance the war. The revenues that are supposed to be coming in for the budget are not coming in. Only half what they expected in taxes is coming in. In the meantime, the expenditures are going to go up, the army is going to demand more, and it means you're going to have a larger budget deficit. With a larger budget deficit, we're right back where we were when we started this lecture. With higher inflation the whole reform is threatened.

The biggest problem of all however is Yeltsin. It's unclear where Yeltsin is on all this. After you finish reading all the different books you heard mentioned today, including mine, go read Yeltsin's second volume of his memoirs. I don't know anybody who lets it hang out quite like that - well, maybe Prince Charles - but Yeltsin talks about his fits of mental depression. He talks about his physical problems, his back, because he's been in a plane wreck, a train wreck, a car crash, he has to take heavy medication for it. But in addition to that, I have a long list of health problems that he has accumulated; he's got circulatory brain problems, the blood in his brain is not circulating properly. He's got a heart problem. He's got a kidney problem and of course he has a liver problem from drinking too much. He issues decrees; he's issued 5500 decrees since he took over as President of Russia back in the Gorbachev era. That's about seven a day. But nobody pays any attention. Nothing happens. Most of us do not realize that in October, after the collapse of the ruble, there was a vote of no confidence in Yeltsin. They needed two hundred twenty six votes to say "no confidence". What happened is that there were only 54 votes for, but there were a hundred ninety four votes no. Well then, how did he win? He won because they count abstentions and absentee ballots as "yes" votes. In a sense, Yeltsin has had a vote of no confidence.

In the midst of this, there's growing anti-western xenophobia. There are many Russians who refuse to believe they could have gotten into problem without foreign interference. They just now passed a rule that says any foreigner living in Russia for more than three months must have an AIDS test. That's an improvement because originally it was said any visitor, any tourist coming in, would have an AIDS test. You don't want to have an AIDS test in Russia because there still aren't disposable needles. Now the KGB has issued a report, there's an English translation of it in the current issue of the Current Digest of the Postsoviet Press , which blames all their problems on foreigners.

Let me conclude. Given what I said, Russia's future is going to be very difficult. You can see what happens when you apply reforms that are misconceived, misguided. And now I understand why there has been such a fierce debate in Moscow all this time. It involves an argument among an economist, an architect, and a physician over who's profession is the oldest. After a good deal of debate, the physician finally says, "I think I've won, I think I can prove to you that the oldest profession in the world is a physician".

The others say, "How can you do that?"

He says, "Well, God was a physician."

"How do you know God was a physician?"

"Well, look in Genesis, the first book in the Bible. What does the bible say? God takes Adam's rib and creates Eve. That means God clearly had to be a surgeon."

But then the architect says, "Maybe you're right, but if you read even earlier in Genesis, go back before Adam appears on the scene. Remember, there was void, there was chaos, and God brought order. So, he'd have to be an architect. Who else is bringing order out of chaos?"

But then the economist adds, "Yes, but somebody had to create the chaos. God must have been an economist!"

Endnotes

Note *: Dr. Marshall Goldman is the Kathryn W. Davis Professor of Economics at Wellesley College and Associate Director of the Russian Research Center at Harvard University. Dr. Goldman has appeared frequently on Nightline, Face the Nation and The MacNeil/Lehrer News Hour. He is the author of a number of books on the economy of the former Soviet Union and Russia. His latest book, Lost Opportunity: Why Economic Reforms in Russia Have not Worked (W.W. Norton 1994), describes the challenges of reforming the Russian economy under Boris Yeltsin. The Economist magazine once remarked that Goldman is "one of America's best Soviet experts." Back.