Russia's economic collapse in August came as a shock to many in the West. Just a few months before, the reform process--involving billions of International Monetary Fund dollars and countless hours of Harvard consultants' time--seemed to be going well: The bulk of state industry inherited from the Soviet Union had been privatized; inflation had been conquered; the ruble had been stabilized. Any visitor to Moscow could see signs of prosperity: a new superhighway circling the city, construction cranes everywhere, streets crowded with cars and lined with glitzy shops. Certainly there was much more to be done, but reform was widely declared to have reached the gratifying point of irreversibility.
By September, all of this had changed. Russia clearly had stumbled on the road to the market. Without the rule of law or secure property rights, privatization had failed to spur investment and growth. Without a functional banking system or a public sector willing to live within its means, monetary austerity alone could not achieve lasting financial stability. And without a respect for social justice based on the right of ordinary people to benefit from the fruits of their own labor, democracy and market reforms became terms of derision everywhere outside Moscow's glittering bubble economy.
For some, the Russian debacle shows that a market economy is not such a good idea after all, at least for Russia. David Johnson, whose electronic newsletter, Johnson's Russia List, is the bible of serious Russia watchers, has gone so far as to suggest that the West should apologize for its advice on market reform. The truth is more complex. The lesson to be drawn from Russia is not that markets themselves are a bad idea but, rather, that it is a bad idea to quickly throw up a market facade before laying a firm foundation. Let's take a look at just how the present sad situation came about.
Privatization without Property Rights
Although Russian President Boris Yeltsin and his team did not get everything right, they at least understood that a market must be based on private property. That was progress compared with Soviet President Mikhail Gorbachev's perestroika. The latter was a lineal descendant of the Lange-Lerner socialist market model of the 1930s, under which owners of state firms were supposed to imitate market behavior in response to artificial price signals from a central authority--an idea Ludwig von Mises aptly described as adults playing at markets the way children play at trains. The Yeltsin reforms, by contrast, were to feature the actual transfer of state property into private hands.
That left open the question of who the new owners should be. There was a widely held view that, as far as economics went, state property could be sold or even given away to just about anyone: workers, former Communist Party officials, the Red Directors who actually ran the factories, or even foreign investors. Whatever the details, it was reasoned, the new owners would have an incentive to maximize the value of their property. If they couldn't run it competently, they would best enrich themselves by hiring professional managers or selling to better qualified investors. While some privatized firms would go under, new start-ups would emerge, absorbing workers and resources released by the failures.
But while the question of ownership seemed of secondary importance economically, it was seen as crucial politically. Key Western advisers like Harvard's Andrei Shleifer argued that privatization would never take place unless those who could block it politically were, in effect, bribed with a share of the spoils.
There was a certain amount of good sense in this view, which was grounded, in part, on Margaret Thatcher's successful efforts to spread the fruits of British privatization widely enough to ensure political support. But what music Shleifer's version of the Thatcher doctrine was to the ears of the Communist Party apparatchiks and komsomol (Communist Youth League) whiz kids who were in a position to make things happen! With the blessing of Western advisers, they helped themselves to whatever choice morsels of state property were closest to hand. Workers at most plants were given large enough blocks of stock to keep them quiet, but with restrictions on the right to sell and other devices that limited their effective control. Small shops were typically privatized by the people who worked in them.
In a massive public relations effort, millions of privatization vouchers were distributed to the public at large, one for every man, woman, and child. These could be exchanged for stock at auctions of state enterprises. But the vouchers turned out to be worth less than $20 each. Most people either sold them immediately, investing the proceeds in a bottle of vodka or a sack of potatoes, according to their inclinations, or else placed them with fraudulent voucher pyramids masquerading as legitimate mutual funds.
In the end, the shares purchased with vouchers mostly ended up in the hands of the same former komsomol wheeler-dealers and Red Directors who benefited from other forms of privatization. Idealistic notions that voucher privatization would lead to a broad-based people's capitalism soon turned to dust.
On its own terms, privatization was a success. In just two years, from early 1992 to early 1994, 104,000 state enterprises were privatized. At the end of this period the private sector accounted for more than 50 percent of GDP and some 60 percent of employment.
Yet the more fundamental goal of a dynamic, prosperous market economy was not achieved. The economic rot that had set in during the last years of perestroika continued to spread. Total output drifted downward year after year. By mid-1998, just before the late-summer crash, real GDP had fallen to just 88 percent of its 1994 level, and it is now less than half of the peak it reached during the late Soviet period. Even before the recent crash, 21 percent of the population was living below the pathetically small official subsistence minimum of $70 per month, and tens of millions of workers had not seen a paycheck for months.
Why did privatization fail? In retrospect, the key problem was the failure to establish a system of law within which owners could defend their property and enjoy the gains from increasing its value.
Lawlessness is a multifaceted problem in Russia. It includes the famous "mafias" that engage in widespread racketeering and extortion. Another aspect is a court system that is poorly equipped to render and enforce decisions in routine matters of business law, such as torts, contracts, and shareholder rights. Corruption of government officials, from the local fire department to the cabinet level, is still another part of the problem. Finally, there are whole bureaucracies, above all the tax service, that do not operate according to law in the classical sense of impersonal, predictable rules on which rational plans can be based. Instead, the bureaucracy acts arbitrarily, ignoring violations of reasonable rules in one case while imposing absurd sanctions in others.
No one of these kinds of lawlessness is unique to Russia. Individual examples can be found anywhere, the United States included. But in Russia, the various manifestations of lawlessness are pervasive, institutionalized, shameless, and subject to perverse interactions to a degree that makes for a uniquely hostile business climate. A couple of examples will give the flavor of the problem.