Zaks Investment Advisory Service

President Yeltsin’s economic policies

Last week saw the passing of Boris Yeltsin, the first elected president in Russian history. A lot of obituaries have been written since – from relatively brief ones in Russia to long and detailed ones on the pages of The New York Times. Yeltsin was first and foremost a politician, but Russia’s economy also changed fundamentally during his presidency. Our program is about finance and investment, and I decided that it would be interesting to discuss the economic consequences of Yeltsin’s work.

Yeltsin brought with him a team of young economists headed by Yegor Gaidar. In contrast to most economists educated in Soviet universities, Gaidar was a follower of market economics. At that time, Russians’ understanding of how a market economy functioned was rather vague. I remember a private meeting at the end of 1992 between academician Oleg Bogomolov, one of Russia’s leading economists who headed one of the economic institutes at the Russian Academy of Science, and a group of University of Chicago economists. The academician complained that prices on some goods had soared, and that an end must be put to speculation. John Gould, the Business School’s dean at the time, tried to suggest that the high prices were simply indicative of a shortage of certain goods, and that those were the very fields where investments should be made. The academic was unshakable in his belief that the whole problem rested in speculation. That was the state of Russian economic thought at the time. Against this backdrop, Gaidar’s group, educated on the books of Hayek and Friedman, simply shone (at least in the eyes of Western economists), and was in any event far better prepared to attempt to reform Russia’s economy.

Gaidar was convinced – and was able to convince Yeltsin – that “shock therapy” was essential for Russia. Many (although not all) Western economists shared his view. All of this was, of course, theory: a transition of a planned economy into a market one of that size was unprecedented. In 1989 in Poland, Leszek Balcerowicz developed and implemented his plan, and it worked: by 1992, Poland’s economy had been restored and continued growing. But Poland was less centralized than the Soviet Union, it still had people who remembered how a market economy works, and the Polish economy had been militarized to a far lesser extent.

What is “shock therapy”? Shock therapy is an attempt to quickly transform a non-market, planned economy into a market one, or into one that resembles a market one as closely as possible. Its main steps are: price liberalization, an end to subsidies, and a stabilization of the budget deficit. Whether shock therapy worked in Russia or not will be debated by economists and politicians for a long time to come. Many critics site a drop in the gross national product – by almost 40 percent between 1989 and 1995, according to official statistics – that came as a result of shock therapy policies as evidence that shock therapy only hurt the economy. I think that things were not as simple as that.

By 1991, the Soviet economy was already in a catastrophic condition, one that was far worse off than official statistics showed. Everyone remembers the empty store shelves. But this was simply a consequence of an economic ruin that unraveled across multiple fronts. In 1991, before the introduction of any reforms, the annual gross national product fell by six percent (it fell in 1990 as well). Professor Anders Aslund studied the economies of the transitional period and offered the following opinion about how Russia’s economy reacted to the reforms. First of all, all Soviet enterprises overstated their output numbers (Aslund believes that this false data added an approximate five percent to the GNP), while in post-Soviet times, everyone started to understate their performance in order to avoid paying taxes. Second, the Soviet GNP largely consisted of goods whose real value was negligibly small (as one person observed, production involved “value detraction” rather than “value creation”): for example, high-quality fish that could have been sold on the world market for considerable money was turned into inedible canned product. This part of production vanished very quickly in the post-Soviet era, taking between 10 and 20 percent of the economy with it. A similar thing, in Aslund’s opinion, was happening to trade between countries of the Council for Mutual Economic Assistance. The only goods of any real value were the natural resource: oil, gas, timber, and ore, i.e. things that had a real market value. These resources were subsidizing most of the remaining trade. This trade also vanished from the post-Soviet space. And, of course, most of the Soviet economy was geared toward an inflated military complex, which also naturally shrunk. In addition, the so-called “black” and “gray” markets, which were not included in the official statistics, to a great extent compensated for the drop in the official economy. So the difference between the “pre-shock” and “post-shock” GNPs is far smaller than might have seemed at first glance. Aslund believes that the economy contracted by six percent – not 40 percent. It is noteworthy that during the hard times of the early 1990s, Russia experienced almost no social unrest. This to a certain extent confirms that, despite all the difficulties, the economy somehow continued to function. Slow reforms, undertaken in Romania and Ukraine, produced considerably worse results. Quick reforms like those in Poland, the Czech Republic and the Baltic states – much better ones.

In theory, reforms should have quickly converted Russia into a market economy. In practice, however, they were executed only in part. There were many reasons behind this. In contrast to Yeltsin, most members of the Supreme Council of Russia were far from convinced that reforms were necessary. The Russian Central Bank was also leading policies that contradicted Gaidar’s ideas. Prices were liberalized at the start of 1992, which led to inflation and the devaluation of savings, but also to goods appearing in stores. However, matters were far worse off on the other two reform fronts: a halt in subsidies and budget deficit stabilization. The point of ending subsidies was to force factory bosses (even non-privatized ones) to stop making useless products and shift to production of something of value to the economy. But the directors, who for the most part had been around for many years, since the old Soviet times, opposed the idea that they had to reform – and, most importantly, scale down: as you probably remember, Soviet enterprises were staffed by hordes of people who often did very little productive work. They continued to produce goods that could not be sold and which no one needed. And they kept these industries afloat by not paying their suppliers (in practical terms – borrowing money from them), withholding salaries, not paying taxes and, in the end, getting relief from Central Bank subsidies that still came. An interesting aside: it is impossible not to pay salaries in the United States. Enterprises that cannot pay salaries end up in bankruptcy, where a judge could sideline the acting managers and appoint new ones. Unfortunately, nothing of the sort happened in Russia: in the early 1990s, it did not even have a bankruptcy law. The Supreme Council, most of whose members believed that the main thing was to preserve the country’s industrial and military potential, fought the reforms tooth and nail. Russia desperately needed to reduce the size of its industrial sector (and to increase the service sector), but progress was painfully slow. Because of subsidies, the budget deficit continued to grow. The Supreme Council’s resistance was so strong that by the end of 1992 the reforms had practically ground to a halt, Gaidar was no longer in government, and the post of prime minister fell to the Gazprom man Chernomyrdin.

One of the most fundamental aspects of Russia’s economic reform and its transition toward a market was privatization. Privatization was headed by the deeply unpopular Chubais. But in the initial years, privatization was quite a success. By the end of 1993, most small enterprises and about one-third of the mid-size and large ones had been transferred into private hands. Most of these enterprises were purchased on vouchers, which were handed out to each Russian citizen. By the end of 1994, the voucher part of privatization was complete. It was presumed that the rest of the enterprises would be sold for cash. What remained was the most valuable part of the economy: oil and aluminum companies, steel mills, companies such as Norilsk Nickel, i.e. those which could directly export their production and earn hard currency in return. The entire remaining portion of the Russian economy was (and, to a large extent, continues to be) uncompetitive. Before privatization, the raw material industries’ directors used the help of banks to organize subsidiary enterprises that engaged in so-called transfer purchases (i.e. purchases made at the nominal price) and subsequent exports, with revenues going directly to the industry bosses themselves and the supporting banks. Privatization was supposed to put an end to this. Unfortunately, it did not.

We will probably never learn why Yeltsin decided on (or allowed) a form of privatization that left gigantic exporters, selling natural resources worth billions of dollars a year, in the hands of a few dozen individuals. Perhaps he sincerely believed that even this was better than inefficient government ownership. Or perhaps he was hoping for political support from the so-called “oligarchs”-billionaires in his fight against communists in the run-up to the 1996 elections. Whatever the case may be, the corrupted loans-for-shares scheme with subsequent – and completely falsified – auctions of state property created an historically unprecedented group of billionaires. In contrast to, say, American billionaires, these people did not create their wealth – as had been done by Carnegie, Mellon and Rockefeller in the past, or by Bill Gates, Steve Jobs and Warren Buffet today. No, they became billionaires because the government handed them the multi-billion, most productive and competitive assets in the economy. Many of these billionaires turned into excellent managers – Khodorkovsky, for example – but this does not change the principle of things.

Could large-scale privatization have been conducted otherwise? Of course. For example, in the Czech Republic, shares in companies were transferred to funds, similar to our mutual funds, which in turn belong to pretty much to the entire Czech population. Meanwhile the enterprise managers, just like managers of large companies in the West, received salaries and options, which rose in price if the enterprise developed successfully.

Yeltsin was unlucky in one respect: during his presidency, the price of oil was incredibly low, averaging out to $25 a barrel in today’s terms. For comparison – under Putin, between January 2000 and today, the average price of oil was $44 (of course, it is higher than that today). It is absolutely evident that had the price of oil been twice as high under Yeltsin, Russia would have had fewer economic problems: the country would have received an additional $400 billion during his reign.

As president, Yeltsin was responsible for many economic decisions, both good and bad. The fact that Russia’s economy is growing today is to his and Gaidar’s credit. And he is largely responsible for the fact that Russia’s economy remains corrupted today. But if we look in retrospect at what happened between the end of 1991 and the end of 1999, we see an economic revolution. It is impossible to compare a collapsing, rotting economy of the Soviet Union circa 1991 to a partially-market, partially-state, largely inefficient, monopolistic – but at least, brimming with potential – economy at the end of 1999. Yeltsin is not loved in Russia today. But I think that people’s opinion will change with time. Through all his shortcomings, he added a great chapter to world history.

This was Sergey Zaks. Thank you for your attention and until next time.