Hearings on U.S.-Russian Relations

Clifford G. Gaddy

Mr. Chairman, members of the committee, thank you for this opportunity to share with you my views on the current state of the Russian economy and its implications for U.S. policy towards Russia.

The acute financial crisis from which Russia may now have gained a temporary respite makes it clear that the time is overdue for sober analysis of Russia’s economic experiment. This means putting aside what I call the “handicapping” system. By that I mean that almost no matter what happens, we can always praise Russia for having made great progress despite its poor starting position. That would be fine if we could keep economies in incubators. The Asia crisis made it clear we cannot. The global financial markets ask only, what return can you give on my money today? They do not care what sort of bad things happened in your past.

These are harsh standards. But they are the ones Russia implicitly chose to accept when it joined the global economy. We supported that choice, even urged it upon the Russians. It is only appropriate that we ourselves look at Russia’s economy in this same, unforgiving light.

By objective measures, Russia’s economy is in a dismal state and is getting worse—even before the current crisis. The statistics agencies reported a growth in industrial output in 1997, but real profits in industry were down by 5%. The share of industrial enterprises that reported losses is almost half—47.3% to be exact—up from less than 27% two years ago.

Investment was down last year for the seventh year in a row (and continues to decline this year). In 1997, the overall level of capital investment in the economy’s production sectors was only 17% of what it was in 1990. In metal-working and engineering, it was an unbelievable 5.3%.

Meanwhile, very few negative signals are being sent about this state of affairs. There are more corporate bankruptcies in the U.S. in a typical month than the entire last year in Russia.

The share of barter in payments among all industrial enterprises in Russia is now above 50%. Last year, 40% of all taxes paid to the Russian federal government were in nonmonetary form. For the very largest enterprises, the percentage was over 90%.

Last December a Russian government commission that studied the problem of barter and nonpayments reached a startling conclusion. Let me quote it:

[We find that ] an economy is emerging where prices are charged which no one pays in cash; where no one pays anything on time; where huge mutual debts are created that also can’t be paid off in reasonable periods of time; where wages are declared and not paid; and so on. […] [This creates] illusory, or virtual earnings, which in turn lead to unpaid, or virtual fiscal obligations, [with business conducted at] nonmarket, or virtual prices.

In short, it is a “virtual economy”—not a market economy, but something quite different, with its own rules of behavior and criteria for success and failure. Professor Barry Ickes of Pennsylvania State University and I have developed a model to explain the logic of this system. We have used this model to explore the implications of the virtual economy for a range of issues, from tax policy, to capital flight, to the role of the natural gas monopoly, Gazprom. Time does not permit me here to elaborate on all this. Let me just emphasize the key point brought out by our research: The virtual economy arises because of two fundamental facts: (1) most of the Russian economy is value-subtracting, while (2) most participants in the economy pretend that it is not. Barter and artificial overpricing turn out to be the main mechanism used to sustain the pretense. The pretense is what causes all the nonpayment difficulties. There is less value produced than there are claims on it and commitments to it.

The virtual economy has clear negative effects. I will mention three:

  • (1) Restructuring. Enterprises don’t restructure, because they can survive as value-subtractors in the virtual economy.

  • (2) Economic performance. Because output in the virtual economy is hugely overpriced, a large part of Russia’s GDP is exaggerated. The alleged GDP growth in 1997 was “virtual,” not real.

  • (3) The public sector. Budgets have little meaning when enterprises pay taxes in kind. Governments have to find ways to use the products and services that the enterprises happen to deliver rather than those society says it needs most.

Nevertheless, the virtual economy is not exclusively negative. It is the social safety net. The virtual economy is robust, well-organized, and broadly popular. To break it would be very costly, socially and therefore politically. This is why Russia’s new government cannot reform in a true sense.

But while the virtual economy provides stability in the shorter term, in the long term it is a dead end. This brings me to the question of the current IMF-led bailout of the Russian economy. I opposed a bailout. I believed, and still believe, that the present form of bailout—bailing out the virtual economy—is not in Russia’s own long-term interest. But now we must think about the future.

The Russian economy is headed for another crisis in the not too distant future. It will be worse than the one we have just experienced. The current bailout package may help stave off a crisis for a year or a year and a half at the most. We would be well-advised to use that time to prepare for the next crisis. By that time both we and the Russians must have already have begun to wrestle seriously with possible solutions that go far beyond the sort of emergency bailout we have just witnessed.

I do not know what such a solution would look like. I do know that it will likely be very difficult and distasteful for both us and the Russians. It will have to involve much more money on our part than hitherto. We don’t like that—at least I don’t. It will involve much more painful dislocation for Russians as they acknowledge the necessity of dismantling their comfortable virtual economy. It will probably require their allowing foreigners to have a direct say in what parts of their rotten economy need to be excised. That is something that is not only distasteful to the Russians, but fraught with political risk.

Many people would prefer that we walk away from Russia and leave them to their own fate. We can’t. Our fate is too closely linked to that of Russia’s to walk away. Neither we, nor the Russians, seem at this point to be prepared to face the depth of that country’s economic and security problems. But I am convinced that without a truly Grand Deal that begins by a stark admission that the virtual economy is not a solution for Russia’s future and ends by addressing both Russia’s total debt problem and its and our own security concerns, we will jointly face a nightmare scenario.

The best possible result of the current bailout is to give us time to develop and discuss solutions that may seem utopian now. The worst outcome would be that it either reinforce our cynicism about the possibility of ever changing Russia, or that it lull us back into the delusion that Russia’s future will take care of itself.

Thank you.