Russia's Economic Failure Jude Wanniski August 27, 1999

In 1989, I was invited to the Soviet Union by "Gosbank," the USSR's state bank, to advise the communist government of Mikhail Gorbachev on a conversion to "market socialism," particularly the development of its non-existent financial market. The invitation came after I had explained to a Soviet diplomat who attended Polyconomics client conference in Boca Raton, Florida, that I believed all the advice his government was getting from U.S. institutions and economists was wrong, and would, if followed, tear the Soviet federation to pieces. To make a long story short, I went to Moscow four times after my first visit in September 1989, advising the Gorbachev government, then the Yeltsin government, on why they had to begin the process of transition to a market economy by fixing the ruble/gold price. I made these visits always at government invitation, but at my own expense. Each time, I was easily outmaneuvered by the International Monetary Fund and its allies in the Bush administration, who recommended "Shock Therapy" as the best formula. The idea, as developed by Jeffrey Sachs of Harvard and supported by Lawrence Summers at the World Bank and Michael Boskin, who chaired the Bush Council of Economic Advisors, was to lift all wage-and-price controls and force an abrupt shift to the "free market."

The New York Times editorial page lent its total support to the idea, believing it would work. The Wall Street Journal editorial page lent its support, correctly believing "shock therapy" would fail and thereby force the dissolution of the Soviet federation. In December 1991, I had dinner in Moscow with John Lloyd, then Moscow bureau chief of the Financial Times, at a point when my ideas were still alive. In his recent NYTimes Magazine piece of August 14, 1999, "Who Lost Russia?" Lloyd concludes that it was in fact "Shock Therapy" that undermined the Russian economy. The WSJournal's George Melloan, who had supported Sachs and "Shock Therapy," last week opined in his column that Lloyd was wrong, that "Marx and Lenin" had lost Russia. The debate now is underway, not quite in full swing, for as Lloyd points out, after a decade of "capitalism" the people of Russia are economically in worse shape than they were under communism. Following is a fairly lengthy essay I wrote in December 1991 on "The Future of Russian Capitalism," which appeared in slightly abridged form in the summer 1992 issue of Foreign Affairs. Note especially my warning to the Russian leaders against taking economic advice from foreign competitors, including the U.S. political establishment, who really did not wish Moscow to succeed in any significant way -- and still do not:

The Future of Russian Capitalism

By Jude Wanniski

Throughout the West, it has for years been assumed that as the transition from socialism to capitalism proceeds in the USSR, there would appear a gradual shift away from strict state control of the means of production toward some form of market socialism. Some property and productive assets would move from collective to individual ownership, but not all that much. Market forces of supply and demand would take over some of the responsibilities of allocating resources, but the state would retain a dominant role in protecting the population from the excesses of capitalism. Moscow would more or less fit itself into the Swedish model. The dynamic of capitalism would be safely subordinated to the imperatives of a welfare state. How could it be otherwise? After seven decades of collectivism, the people of Russia and the republics must surely have lost all memory of commercial competitiveness. Or so the opinion leaders of the West have concluded.

This need not be so. In fact, quite the opposite conclusion might be drawn. For the 70 years of the communist experiment, the competitive impulse of Soviet man has not been extinguished at all, but has rather been channeled into the awkward mazes and blind alleys that ultimately led to abandonment of the Marxist-Leninist idea. Now freed of these constraints, it is even easy to imagine these competitive impulses racing ahead of a Western form of corporate capitalism that has grown flabby and slow. It is possible to imagine a future of Russian capitalism that asserts itself early in the 21st Century as the envy of the world. In this difficult time of Russia's conversion from one system of political economy to another, it might seem sheer fantasy to present such a notion. The objective, as an alternative to the Swedish model, is worth considering, however. The Russian people are now engaged in nothing less than designing the basic architecture of a brand new country. Why not consider all possibilities? Simply because the people of Russia were bested in this one competition does not mean they must henceforth sit on the sidelines of history. Why not aim to win the competition of the next century? Why not design the Russian system of capitalism to be the best?

In September of 1989, the Soviet Government invited me to Moscow, along with a governor of the U.S. central bank, Wayne Angell, to offer advice on how to make the change from one system to another. This is precisely what we suggested at the time. "As long as you are starting fresh," Governor Angell told a gathering of officials at the old Soviet Gosbank, "why should you try to be the tenth best, or the fifth or third? Why not shoot for the top?" In the two following years, I have twice returned to Moscow at the invitation of the Gorbachev government to outline a strategic growth path that would shoot for the top. In both cases, my ideas were lost in the politics of the old regime. In November of 1991, though, I was invited again to Moscow, this time by the Yeltsin government's Ministry of Economics and Finance. Now, for the first time, this concept of a growth path has been engaged. The New Jersey company I founded in 1978, to advise the world's leading industrial and financial corporations, is now an official advisor to the new Commonwealth. Its mission is to design options of a streamlined growth strategy that would get Russia off the sidelines and back into the race as soon as possible, with the least distress to the population, and the greatest chance of success.

We begin with a critical question: What kind of capitalist country does Russia want to be? To the readers of Novy Mir, the question itself must seem unusual, even provocative. How does one find out what a country wants to be? A country, after all, is an abstraction. The population of the country knows what kind of capitalism it desires. At least we can say that if it were presented with clear descriptions of all the available kinds of capitalism, and were able to pick and choose among them, the people would select one variety over all others. This is not an assertion, but an axiom. We have to assume that the people of this new country, in aggregate, would have an opinion on what system would be best for them as they set out on this new experiment in political economy. If only we could find what it is, we would make the people happiest by trying their opinion before all others. This, after all, is what democracy is all about.

In other words, there is no evidence that the people of Russia and the Commonwealth's constituent republics would at this early point in the life of the Commonwealth prefer a version of state capitalism over a version of entrepreneurial capitalism. The Commonwealth's intellectual leaders should not, then, simply assume, as the West has, that Russia in the 21st Century will choose a Swedish model of state capitalism over other possibilities. Indeed, Russia's intellectual class should consider the possibility that the West may not be the best source of advice on how to proceed. Why would a businessman who has lost ground to a competitor expect the competitor to give him wise counsel on how he might win in the next round? A victor wants to stay on top. It cannot do so if it gives away the secrets of its winning strategy. Russia should decide, on its own, how it should design its strategy for the race ahead. It should look to the West for all available options, one of which it must choose through the democratic process. If a Russian leader is not prepared to put his choice of options to a vote of the people, it is a sure sign he doubts the wisdom of the course he has been advised to take by leaders in the West. If democracy means anything, it means the wisest course will be popular.

What follows in this essay, then, is meant only as an option. After all, I am a foreigner, which means, by my own argument, that I might not wish the success of a Russian competitor over my own country in the contest the next century will bring. On the other hand, as an American patriot, I would be encouraged if the soft, flabby form of capitalism my compatriots seem willing to accept these days could be aroused by a new competition from Moscow. In horseracing parlance, everyone gains with a general improvement of the bloodline.

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Before we explore the future of Russian capitalism, we should be clear about the past. It is my opinion, at least, that Karl Marx was extremely close to the truth when he completed his examination of capitalism in the midst of the 19th Century: Capitalism could not succeed because capitalists would sow the seeds of their own destruction. That is, if capitalism requires relentless competition, yet capitalists are doing everything they can do destroy competition, we have a system that is inherently unsustainable -- as with animals who devour their young.

Here is the problem: If successful capitalists can control the apparatus of government in order to prevent a new growth of capitalists, the system will inevitably destruct. If a system can be devised that prevents successful capitalists from controlling the apparatus of government for their narrow interests, though, there is at least a chance of renewal and a chance of success. The system Marx did not contemplate took another half century to reveal itself. It came in the form of the Australian ballot: A secret political ballot, the key to democratic choice, the key to unlocking the wisdom of the masses. If the people collectively know which course of action is the wisest, as I believe they do, they must be provided a safe channel to express that opinion. In creating a system of Russian capitalism, there is no more important ingredient than this -- a democratic mechanism that protects the collective wisdom of the electorate. Mikhail Gorbachev called it glasnost. In that he was correct: The democratic structure of the political economy is far more important than the economic structure. The economic structure must change continually, to keep up with changing times in a competitive world economy; an optimum democratic structure provides the foundation of such change, enabling the people to exert their wisdom in guiding the direction and contour of economic change.

Even then, it is not enough to have democratic mechanisms in order to thwart the most determined corruptors of capitalism. Capitalists are forever trying to use their power in government to protect their businesses against foreign competition, through higher tariffs or non-tariff regulatory barriers. As I demonstrated in my 1978 book, The Way the World Works, the Wall Street Crash and the Great Depression of the 1930s was the direct result of such trade protectionism in the United States. Ordinary people at the time did not vote for such policies. Indeed, they voted for politicians who were seemingly opposed to trade protection. The worst policy errors occur not because of voting decisions of ordinary people, but by politicians who break their promises to the people in between elections. For this reason, in the design of a democratic political mechanism for Russia, the most advanced democratic processes should be adopted, including national initiatives and referendums that can be triggered at any time between national elections, in order to keep politicians from straying from the commonweal.

At the moment, no such mechanism exists, but there is immediate need for economic relief. From a distance, I have watched the leaders of the old Soviet Union struggle to find a new path. My suggestions on how they might move more easily, with less distress among the people, flow from a few simple observations. One involves form. The other involves substance. That is. if you stand outside the unfolding history of events now underway in the republics, almost as if an observer from another planet, you come to these elemental considerations:

1. Think of the current status of Russia and the republics as bankruptcy proceedings, the bankruptcy of the old USSR. The corporation which we had called the Soviet Union can no longer pay its bills. And, as in any bankruptcy proceeding, the creditors are crowding in to get paid, trying to elbow their way to the front of the line. There are two classes of creditors here, foreign and domestic. Thusfar, the foreign creditors have been most successful in crowding their way to the front of the line, persuading first the Gorbachev government, then the Yeltsin government, to put them at the head of the line. The government has put the domestic creditors -- the people of the old Soviet Union -- at the end of the line. Indeed, they have come close to advising the people that they intend to cheat them out of their ruble claims against the government, their lifetime savings and pensions. This has been the advice of the Western creditors, who suggest that the ruble savings of the ordinary people of the republics is a barrier to progress. They see it as a "ruble overhang" that could suddenly come out of savings for spending purposes, igniting inflation. Of course, this is nonsense. The ruble savings of the people are the foundation of the new Russian capitalism and should be preserved and protected. We must include here the value of pensions, which should be restored to their level of purchasing power that existed prior to the recent inflation.

2. The substantive objective of perestroika is an extremely simple one: Because of the nature of the failed experiment with communism, the wealth of the nation is held collectively; a strategy must be developed that will, as equitably as possible, turn collective wealth over to private hands. The managers of the state will of course try to preserve as much wealth in state hands as they can. Foreign investors will also try to crowd into privileged positions when state assets are offered for sale. It is the strength of the democracy alone that can offset these forces and place the assets where they belong, at least to begin with, in the hands of the ordinary citizens. The political leadership must be determined to place at least half (why not most?) of the nation's collective wealth into individual hands, insisting that foreign individuals or corporations be permitted to buy assets only from the citizens in the open market. Because great wealth and natural resources are involved, it will take great political resolve to prevent the people from being cheated of their due through bribery and corruption. Russian capitalism must have this moral foundation.

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Much is made by some Western analysts of the absence of the legal forms of capitalism: courts to enforce contracts, a clear legal code, a transparent system for making regulatory decisions that affect business. This argument has great merit, because in Western democracies the state stands over the marketplace as referee, discouraging individuals from cheating one another, just as the police discourage individuals from robbing each other in the street. Even more fundamental, though, to the success of Russian capitalism is that the state abstain from cheating the people. In that regard, Western democracies are not as pure as they might like to represent. If one individual owes another $100 and decides to pay only $50, the debtor has recourse to the courts to exact payment. But if the state decides to reduce the purchasing power of its currency by 50%, what recourse do individuals have? In Western democracies, debtors (including the state, which is always the biggest debtor) gain from devaluation of the currency, while creditors lose. Devaluation thus redistributes wealth arbitrarily among citizens. In Russia, where private debt does not exist for all practical purposes, the devaluation of the ruble represents nothing more than a transfer of wealth from individuals to the state. Excepting automobiles, household appliances, furniture, and hoards of consumer goods, all private wealth in the republics of the former USSR takes the form of currency or bank deposits held by individual citizens. These are debts owed by the state to the people. If the state devalues the ruble, it cheats the people out of their savings. What good is contract law or courts to enforce it, if the state can rob the people with impunity?

All Western economists as well as the Russian government agree that the Russian economy can only recover if the state transfers property to the people. Under the advice of Western creditors, the Russian government has gone in precisely the opposite direction. While the government negotiates with the West over $10 or $20 billion of emergency credits, it has virtually eliminated 600 billion rubles of private wealth through the devaluation of the currency. This savings wealth accumulated over decades in which the purchasing power of the ruble was roughly equivalent to a dollar; a dollar could buy a loaf of bread, so could a ruble. In that light, the people have had their entire personal wealth, $600 billion, repudiated by the state. In sheer size, that is an expropriation of private wealth comparable to the forced collectivization of agriculture during the 1930s. Its economic consequences are no less devastating, even though it was accomplished without violence and deportations.

To estimate the disaster wrought upon Russia by the devaluation of the currency, we must begin with a concept that Karl Marx omitted from his economic model, what Western economists call "transaction costs." Transaction costs are ultimately determined by the degree of risk involved in economic activity. The social cost of a commodity is quite different if a producer can sell it in a moment in an efficient market, or if the same producer must hire a dozen bodyguards to avert robbery on the way to the market. To avert robbery by the state, citizens of Russia must first convert their rubles into some store of value and then find means to barter these stores of value for products they need. Farmers will not sell wheat or milk for worthless rubles; they would rather feed their produce to pigs, which represent an interim store of value. Thus we see ordinary citizens waiting on queues for many hours to exchange depreciating rubles for consumer goods, individuals spending hours in the market trying to exchange one good for another, and industrial managers spending weeks attempting to obtain goods they need by an elaborate chain of barter. In a modern industrial economy whose daily activity requires a division of labor of millions of workers producing tens of thousands of different commodities, the social costs of a barter system are catastrophic; the costs of simple transactions eat up most of the economic effort of society.

It is no surprise, then, that Russia is now experiencing a spiralling economic collapse, with the great majority of its citizens reduced to the most abject poverty, the diet of most citizens limited to sufficient carbohydrate calories to sustain life itself. No one believes that this situation can continue for long without catastrophic social and political consequences. It is equally obvious that the state must convince the people that it will not rob them, i.e., that it will preserve the value of its debt held by the people, for the crisis to be overcome. Once the state honors its obligations to the people, the creation of a legal code for business and related matters can be attended to expeditiously. But how is this to be done? The state itself is in the grip of a vicious cycle: the collapse of the ruble has forced an ever-growing proportion of transactions into the barter system, wiping out government revenues. The state, in turn, is forced to print money to meet essential expenditures, since its revenues shrink much faster than it can reduce spending. By flooding the market with newly-printed money, the state further reduces confidence in the ruble.

If the Russian state were a private firm within a Western industrial country, the problem would never have arisen. Russia is rich; the assets of the state, land, structures, capital equipment and mineral resources, amount to trillions of dollars by the most conservative measure. Its debts amount to less than a trillion rubles. Even if the ruble were valued at 1:1 to the dollar, its assets would exceed its liabilities many times over. A Western firm with such a favorable position would have no difficulty in raising ready cash by borrowing against the collateral of its assets, or selling some of its assets to investors. The existence of capital markets capable of converting wealth into ready cash, though, depends upon the existence of trust between creditors and debtors, something that Russia has yet to achieve.

By the most optimistic estimate, Russia will require several years to privatize the bulk of state properties. It cannot exchange the state debt in the form of currency or deposits for houses, mineral rights, or industrial shares quickly enough to stabilize the ruble. It must therefore persuade the people to wait for a number of years, offering capital instruments -- bonds -- with a corresponding maturity. The value of the ruble should be in accord with the value of Russian labor; at the current black market exchange rate, a Russian worker earning the average wage of about 900 rubles a month earns barely US$6. Assuming that Russian labor is worth on the international market what workers earn in middle-income developing countries, the proper exchange rate for the ruble should be around 2 to the dollar. That should be the target for the exchange rate. The government bonds must be indexed to gold or foreign exchange at this high rate.

Russian officials worry that the people may not trust the government sufficiently to have confidence that these bonds will be redeemed at a favorable exchange rate. Trust is a formidable obstacle, and will require all of the state's resources to achieve. I have proposed that part of a gold-indexed bond issue be sold on international markets, to Western investors. A secondary market would then exist for such bonds in hard currency; Russian citizens would, if they chose, be able to sell bonds bought with today's rubles for hard currency in this secondary market. That is an essential element for establishing trust. It is important to take into account, though, that the state has never attempted to offer the people the chance to hold financial assets which will preserve the value of their savings. It has offered them only low-interest deposits or low-interest, long-term bonds which the public has rejected. If the government clearly explains the nature of the problem to the people and shows how it intends to make good on its obligations to the people, it still has a fighting chance to win their confidence.

Once current rubles are convertible into a financial asset which pays a dollar for every 2 rubles, rather than every 130 at today's distorted black market rate, a floor will be placed under the ruble's value. It is hard to tell where that floor will be, since it depends upon the public's confidence in the new government bonds. Certainly, the ruble's value will rise to fewer than 10 to the dollar, perhaps to fewer than 5. Farmers will again sell wheat and milk for rubles, rather than feed them to pigs, and a flood of hoarded goods will appear in the stores.

These measures alone will not solve Russia's economic problems. On the contrary: they are the precondition for solving them. Russia will require a new legal system, a tax structure which permits producers to operate with the least burdens, regulatory mechanisms which do not impede economic activity, and a variety of other reforms. All these improvements are possible once a basic condition of trust is achieved between the state and the public. If the state accepts the premise that its obligations to the people are sacrosanct, Russia's leaders will have little difficulty in persuading the public that all these reforms are in the general interest, since the vast majority of individuals will stand to benefit from them.

It was in just this fashion that the United States began its life 200 years ago. In literally hundreds of hours of discussions I've had with innumerable Soviet and Russian officials and opinion leaders, this story is one that never fails to hold their attention: Then, as now, there were voices in the first administration of George Washington who urged a policy of debt repudiation. The new country was burdened with great debts to its own people, incurred during the fighting of the War of Revolution. It also owed a large amount to creditors in Holland, who had helped finance the war. The first American Treasury Secretary, Alexander Hamilton, insisted this was not the way to begin as a new nation, by declaring bankruptcy, thereby cheating creditors at home and abroad. A new country, like the life of a new baby, should expect to incur debt for many years before it matures, and is able to redeem its obligations. The United States began its life on this moral principle, establishing a bond of confidence between the state and the people that became the foundation of the great enterprise that soon became the envy of the world. The new Commonwealth will find this policy will serve it just as well. Investment will soon flow from abroad, and from the toil of the people, as they note the integrity of the new government.

The metaphor of a newborn baby will serve in many ways to guide the intellectual and political leaders of Russia. If Russia would now try to be like the United States is today, the baby would strangle in the cradle under the smothering weight of complexity. The future of Russian capitalism lies in the lessons of America's past. Honesty in its money is but one element. Simplicity in law is another. In the United States now, more than 700,000 lawyers ply their trade, draining off the energies and talents of a nation in empty legal skirmishing. Battalions of accountants are required to fathom the dispiriting intricacies of the tax laws. Bank regulations have become so unfathomable that ordinary people increasingly find it impossible to borrow. The government has become dominated by aging capitalists who add layers of complexities to prevent new competition from below. The freedom and flexibility of America's youth has become bound like Gulliver.

If Russia is to leap ahead after 75 years of stagnation, it should be resisting all advice that comes from the West which only complicates growth. Americans can now only dream of how nice it would be to start anew in the United States, with a blank slate on which we could write simple tax and regulatory legislation. Complexity serves the interests of the elite, who know how to pay their way around it. It confounds the interests and opportunities of ordinary people who are hoping to get ahead. If Russia can think of itself as a nation of young capitalists, striving to attain a potential that now seems limitless, the path to its prosperous future will more easily be seen.

Two centuries ago, the elite of the Old World looked smugly on the ragtag enterprise of the new United States. We can be sure there were many who were amused at the notion that Americans would ever amount to much. These Americans would surely be confounded by the wilderness, the native savages, and the absence of experienced institutions capable of dealing with the intricacies of modern politics and commerce.

We Americans, in turn, may now be tempted to become Old Worldly ourselves, viewing the new Russian enterprise with patronizing amusement: It will surely take these Cold War losers a generation or two before they learn the sophisticated nuances of modern business and finance, to the point where they will understand the profound importance of a leveraged buyout. Will it not?

Then again, perhaps we could consider the new Commonwealth as a kind of new frontier, an adventure on the planet that will soon be exploring far more interesting possibilities than leveraged buyouts and convertible debentures. Across the great expanse of eleven time zones, Russia and the republics are like so many liberated colonies, suddenly freed of the straitjacket of the communist idea. We should not forget that the idea was simply one that would subsume individual risk-taking and reward to the security of the community, the commune. The experiment in political economy did not work and the people who were subjected to it are eager for a system that will. If our own history is any guide, we should expect in this brand new country an eagerness for opportunity and an explosion of risk-taking and entrepreneurial ferment. The people of Russia clearly look to the United States, not Europe or Asia, as the exemplary model. We should be happy they do and counsel them in that spirit, not as old adversaries or potentially new competitors, but as converts and potentially new allies. It will make a great difference to the shape of the Twenty First Century.