Russia’s Economic Future

October 30, 2002

ProFile: What is the “virtual economy” and what is its relation to the real economy?

Gaddy: It’s the notion of fictitious value, prices not determined by the forces of supply and demand. In transactions among enterprises, you have fictitious taxes being levied and paid, and fictitious budgets—what we’re talking about is an interconnected system. It’s not a separate economy—you can’t divide a regular economy and the virtual economy, it is interwoven into all economic transactions.

We had a real enterprise director called “Igor” who was instrumental in developing the concepts behind the book. We were looking at the non-payment of taxes, and I asked him in 1997 about his attitudes toward taxes. I said, “Everyone I talked to says it’s a huge headache, how about you?” He said, “No problem. We paid all our federal taxes. Of course, the central government doesn’t always agree with us, and they send us letters saying you owe us this and this. But then I just send them a letter that says “you’re right, but on the other hand your Ministry of X, Y, Z owes us for the goods we delivered to them.” So we send these letters back and forth, but ultimately we decide—let’s just call it even: you owe us, we owe you.

He said: “I have four rules for how you prosper as an enterprise director in today’s Russia. First—have some contracts with the federal government, have some state orders. And if you’re smart, you can get the same amount of state orders that you expect to have to pay in taxes. You know they’re not going to pay you for those orders, but it’s just enough to offset your federal taxes. Second, you want to do the same thing for your local government, but you need to provide services for them, repairing schools and roads. Third, ideally you want some goods you can provide as barter to the large monopolies like Gazprom, because you always need their services, and if you have something they can use, you can get by without cash. Fourth, you may need some cash, so it’s good to have something that generates cash, and the most reliable is to export some product to a hard currency market.” He produces some steel for export, and he’s found a great way to take advantage of it, even though he’s not a low-cost producer of steel. Here, it’s perfect, because he needs some cash to pay wages—despite all the stories of Russian workers being paid in toilet paper—clearly most of them need and do receive cash. And there are other reasons—if it’s a vitally needed good, and you need it quickly, you might need cash, or if you need to import products. And as an afterthought he said, “Oh by the way I have a fifth rule—don’t make any profit, they’ll just take it all.” And you have to realize, this was not your traditional hopeless dinosaur of an industry—we’re talking about a company that had joint ventures with top American electronics producers, hundreds of trained employees. What was important about this is that he was the hope and the future of Russian manufacturing industry, telling us about ways that he was avoiding doing the very things that the country, the economy, and the society needed him to do. This was the real tragedy. And he could make profits, but he doesn’t want to. That inspired us to work out the economic model of this virtual economy.

The real problem of Russian transition is not replacing the central planning institutions with market institutions or laws, it’s not liberalizing prices or privatizing enterprises; the real problem Russia has to face is: what do you do with all the mistakes that were made in the seventy years of the past system—the factories that were built to produce the wrong things, the factories that were built in the wrong places, entire cities built in the wrong places—and when I say wrong, I mean: they would not have been there if Russia were a capitalist country—cities like Perm, Yekaterniburg, Omsk, Novosibirsk—there was quite serious misallocation that came about because of a system that didn’t recognize real costs and real prices. In effect, the whole Soviet system was clearly a system of virtual non-market pricing. There are no historical precedents in the modern industrial world for the kind of territorial reallocation that would be necessary to make Russia more efficient. You’re left now with a structure of the economy that is not competitive, because you’re now competing with the rest of the world, and your objectives are different—to maximize the welfare of the citizens, to produce goods and services that not only the Russians want, but which the rest of the world wants, and which they will compare to with goods and services produced by other countries who have had the great fortune of not having 70 years of misallocations in their economy. Replacing an old system with a new system is a huge challenge, but undoing the mistakes of the past is a much bigger task. And I say that not to be pessimistic, but to be realistic and to put these tasks in front of Russian leaders, so there’s no illusion.

ProFile: Is there a way out?

Gaddy: The way out is extremely difficult. These problems will not be solved by letting things proceed naturally. Russia is not at some half-way point between a centrally-planned economy and a market economy—it takes on rules of its own that might lead somewhere else. Conscious policy has to be made. This requires incredible amounts of political leadership and mobilization, and I can’t see Russia doing that on its own. I’m not talking so much about external financial assistance, but I think there’s one absolute pre-requisite, and that’s Russia’s security environment. If Russia cannot feel that it’s physical security is assured, a Russian leader would be crazy to undertake the kinds of reforms I’m talking about, because they would be socially and politically disruptive, and they’ll tear at the fabric society.

Many of these choices are between bad and worse, and it’s not the fault of the people making the choices today, and it’s not the fault of the people who made choices over the past ten years. That kind of debate—what kind of mistakes were made by the reformers, did they reform too fast or too slow—is not that productive, because the choices they had to make are small issues compared to the gigantic burden they inherited from the past. The socialist system was so bad that even the power of the free market can’t automatically solve all the problems. The focus should be on the initial conditions.

ProFile: Can you compare the Russian virtual economy to the Enron scandals?

Gaddy: I wouldn’t want to compare it, we’re talking about opposite ends of a continuum. We develop a concept in the book called “relational capital”—in addition to physical and human capital, a director has relations with other players in the economy—other factory directors, and bureaucrats who control the flows of wealth from the government, and the enterprise chooses between investing in physical capital and making a value-added product, as in a normally functioning market economy; but it might be more profitable in enhancing you relational capital, improving your relations with individuals so that the company can prosper while avoiding the discipline of the market system. It’s sort of a question of “softening” your budget constraint—what sort of behavior can you engage in to make it possible for your company to survive even though your company is not producing a better product more cheaply, and doing all the difficult things you need to do, rather you’re getting all kinds of subsidies. You can get hidden subsidies by influencing privileges on tax rates and payments, or—most typical in the Russian case—is the ability to engage in barter with very non-transparent prices. A product that on the open market might have a price of 10, used in these relational networks might be priced at 20—you have a phony price, a “virtual” price that’s not determined by the marketplace.

In the Enron case, there was clearly a lot of relational capital building, allowing them to engage in accounting fictions. The difference is that Enron scandal blew up in the US. A market economy is not perfect—it makes mistakes. It makes continuous mistakes, but they are small, and they will generally be discovered, and they will be corrected. Enron is so particular because it grew to be so large and concealed things for so long; it’s an anomaly. There’s a sense of competitive discipline in the open market that forces mistakes into the open, where they are corrected.

In Russia, August 1998 was a surfacing of the Russian virtual economy, and that was the penalty that was paid. But in contrast to Enron, there were not a lot of congressional hearings in Russia, saying “we need to get rod of this cancer, we need to wipe this out.” The reason is because it’s much bigger in Russia, it’s a cancer that has metastasized throughout the whole organism, it’s incredibly difficult to get rid of it.

ProFile: What role do small businesses and new businesses play in this economy?

Gaddy: Relational capital is key—the new players, the businesses that started from nothing, almost by definition have no relational capital—they have to operate by market rules, in a system that imposes market discipline that says: “If you don’t produce a better product more cheaply and market it better, you cannot succeed” They cannot hope to have some special ties to the governor. Of course we know this isn’t exactly true, there are a number of business that were started by the governor’s brother-in-law or something, but if you look at these businesses you’ll find that they’re really just looting operations.

One reason you cannot put your hopes exclusively on the small news businesses is they’re going to be squeezed. Who’s going to provide tax revenues?—typically it will be the foreign businesses, because they pay their taxes, and the small businesses, who have no connections, so the tax inspectors get in there and squeeze them. The real value producers, the small businesses will be there as cows to milk, and that’s not a good solution either. In the worst case, they’ll actually be sucked into being forced to play the same system, despite their best intentions. They’re in there to survive; if survival means making a profit from selling goods, then you make profit. If you can survive with other means, by receiving subsidies and tax breaks, people will do it, especially if it’s legal. The small businessman is not going to forego the opportunity to go into one of these deals if the opportunity presented to them, so they can be sucked in. One of the questions is, how do we insulate the two systems, and let the good healthy part grown, and let the old part shrink. Not be killed, necessarily, because so many towns and families depend on them. With a big proactive effort to increase mobility, to let people—if they want to—make it easier for them to move from these areas that simply don’t have, shouldn’t have a future. I don’t think policy-makers should say: “We think Nizhnii Novgorod should be the new metropolis. You can’t pick the winners of citites anymore than you can pick the winners of different sectors of industry. But you can at least begin by stopping saying things like “We need to repopulate Siberia” like Mr. Putin says—that is not a good thing to say. Throughout the world, throughout the entire northern hemisphere, at least through the twentieth century, there has been a movement to warmer places. It’s more productive—it makes sense. Russia is the only place in the world that went the other way. We created an index called temperature per capita—rather than taking an average temperature over a whole territory, we created a population-weighted average by looking where people live. And that means the temperature can change—if everyone moves to a warmer climate, that raises the average temperature of the country. When you use that index to look at every other country in the world, you see that everyone is getting warmer, at least those countries big enough to have a temperature range. And then you see Russia, and it gets colder and colder. Fortunately, it bottomed off at the beginning of the 90s, but the bad news is, it doesn’t get warmer.

ProFile: Is it possible for Russia to have its own economic path?

Gaddy: Absolutely. There will be specific Russian characteristics even in a healthy economy. The legacy of the past is also not going to disappear overnight. Since no one has these problems, no one else has tried to solve them, that means that whatever Russia does will be different from anything else. Russia will probably always be different, but other countries are different as well—the Scandinavian countries have a specific tinge to the their model, French and German and Brazilian and others. Some people tend to exaggerate those differences and fail to realize that when it comes down to it, in a global economy, you’re still competing with each other, and that tends to make things more uniform, in a fundamental sense. That means if Russia is truly going to be a part of the world economy, its economic policy is going to have to obey the same rules as the rest of the world. I think it’s reasonable to assume, though, that Russia is going to be more different than any other big economy, and for a longer time. That might not be for the best—those differences may continue to make Russia less competitive, but if Russia continues to become a more developed market economy and a more advanced democracy, the Russians may be willing to make that choice—we’re not willing to give something up, even if it makes us less competitive. Lots of countries have made that choice—Scandinavian countries decided they were willing to pay for a very extensive social welfare system and an egalitarian distribution of income.