SHOCK THERAPY AND ECONOMIC POLICY UNDER YELTSIN

ECONOMIC POLICY UNDER YELTSIN

In October 1991, two months before the official collapse of the Soviet regime and two months after the August 1991 coup against the Gorbachev regime, Yeltsin and his advisers, including reform economist Yegor Gaydar, established a program of radical economic reforms. The Russian parliament, the Supreme Soviet, also extended decree powers to the president for one year to implement the program. The program was ambitious, and the record has indicated that the goals for macroeconomic stabilization and economic restructuring programs may have been unrealistically high. Another complication in the Yeltsin reform program was that after 1991 both political and economic authority devolved significantly from the national to the regional level; in a series of agreements with the majority of Russia's twenty-one republics and several other subnational jurisdictions, Moscow granted a variety of special rights and powers having important economic overtones. [Source: Library of Congress, July 1996 *]

As president of the Russian Republic, Boris Yeltsin already had advocated substantial economic reform prior to Russia's independence, in order to begin resurrecting Russia's economy from the crisis of the last Soviet years. After Yeltsin took office economic reforms such as ending price controls and the privatization of state-owned companies took place. The end of price controls resulted in a more market-oriented economy but produced hyper-inflation. Swift privatization of Russian industry produced a super rich elite and poverty-stricken masses not a middle class.

Russia’s economic reformers were branded as good guys by the United States. Yegor Gaidar was the architect of Yeltsin's original economic plan. International lenders such as the International Monetary Fund (IMF), the Paris Club of Western government lenders, and the London Club of international commercial banks have provided substantial aid, with the caveat that Russia must improve economic indicators such as its inflation rate and budget deficits.

Many of the goals of the Yeltsin program were met at least partially in the early post-Soviet years, depending on which statistics are used to define economic trends. Foreign trade was liberalized significantly, and the list of Russia's trading partners became dominated by West European rather than East European and former Soviet countries.

Yeltsin’s First Wave of Economic Reforms

For the new Russian Federation, the Yeltsin administration set ambitious economic reform goals in 1992: strict limitation of government spending to cut inflation; redirection of state investment from the military-industrial complex and heavy industry toward consumer production; a new tax system to redistribute financial resources to more efficient sectors; cutting of government subsidies for enterprises and eliminating government price controls; and lifting of government control of foreign trade. Privatization of the major sectors of production, still virtually state monopolies in 1991, was another primary goal. [Source: Library of Congress, 1996 *]

In 1993 and 1994, soaring inflation and government deregulation of prices robbed consumers of much of their purchasing power before a government tight-money policy brought inflation under control in 1995 and 1996. In December 1996, prices rose by 1.4 percent, although wage arrears made that figure irrelevant for many Russians.*

In 1992 worsening economic conditions brought a confrontation with the Supreme Soviet (legislature) over economic policy. The clash forced Yeltsin's dismissal of reform Prime Minister Yegor Gaydar and a general modification of reform goals under Gaydar's pragmatic successor, Viktor Chernomyrdin. At that point, failing enterprises still received easy credit from the banking system and from other enterprises--a continuation of Soviet-style fiscal management and a crucial flaw that began to be corrected only in 1995.*

The course of foreign investment has been uneven. Although Western and Japanese firms have shown great interest in joint ventures with Russian enterprises, Russia's unfinished and uncertain commercial and legal infrastructure has limited foreign participation, and protectionist laws restrict foreign activity in industries such as communications and automobiles.

Shock Therapy for the Russian Economy

In 1991, Yeltsin initiated a reform program that fell in line with the "shock therapy," a strategy in which a country switches over quickly to a market economy employing price liberalization, budgets stabilization, ending subsidies and privatizing industry. The primary aim of shock therapy is to change the economy as quickly a possible to a market economy. The main cost is that inefficient companies quickly go out of business and large numbers of people become unemployed.

Under the Russian "shock therapy" program, Yeltsin phased out state subsidies, freed prices, reduced government spending and privatized state businesses. shock therapy, relinquished control over the ruble, and freed prices, which had been held artificially low, on consumer goods but kept prices fixed in oil, timber and minerals.

The "shock therapy" strategy was partly devised by Harvard economist Jeffrey Sachs and supported by Lawrence Summers, the U.S. Under Secretary of the Treasury in charge of International Affairs. Sachs made a name for himself by developing an economic strategy that ended Bolivia's 24,000 percent of inflation. He was called on to develop an economic strategy for Poland and then was asked to do the same thing for Russia.

Sachs and Summers encouraged the United States to push the IMF and World Bank to lend Russia tens billions of dollars to prop up the ruble so it could be internationally convertible and attract investment and kickstart the economy.

In 1991, the economy was already in chaos and the changes didn't help matters. There were huge budgets deficits. The harvest was the lowest in years due to breakdowns in the distribution system. Some regions hoarded foodstuffs and declared autonomy and control over their resources. In the end real shock therapy did not take place. The government was unwilling to face the unemployment, bankruptcies and other hardships that would take place if the shock-therapy reforms were taken. Many economist feel that even if shock therapy was fully implemented it wouldn't have succeeded because Russia is too big and fundamentally different from the West for Western strategies to work.

Problems with Shock Therapy

The shortcomings of the shock therapy strategy used in Russia included: 1) inexperience of Russia in acting under honest and civil "capitalist rules of behavior"; 2) lack of consensus in Russia about how to approach the country’s future; 3) Russia's massive size and the difficulty of making change in a place so vast (Poland by contrast is much smaller).

Vyacheskav A. Nikonov, an analyst at the Politika Foundation, a Moscow think tank, told the Los Angeles Times, Westerners "came here with recipes that in principle can be implemented only in countries with a developed market economy. They suggested Russia live by the laws of a normal market system when even the legal basis for a free market was not even yet constructed, and when no one in the country had a clue what a market was all about.”

One of the biggest critics of "shock therapy" was Joseph Stiglitz, a Nobel Prize winner and the chief economist of the World Bank. He felt controls were necessary and the policy was based too much on ideology and wishful thinking. "The standard Western advise," he wrote, took “an ideological, fundamental and root-and-branch approach to reform-mongering as opposed to an incremental, remedial, piecemeal and adaptive approach."

Stiglitz wrote: "Those who put privatization above all else were wrong. Summers and Sachs and others thought that had to pursue privatization, and infrastructural changes would follow: They thought that new owners of private property would demand that this happen. But instead they took their money out."

Instead of the free hand of laissez faire economics, Stiglitz said the Russian economy was governed by the "grabbing hand theory" in which the state is "irredeemably corrupt" and players in the system seize and plunder assets and do nothing to create new jobs and promote growth. Stiglitz believes that privatization should have taken place only after sound laws, regulations, property rights, proper banking institutions, and working markets were in place. He held up China as an example of a better approach.

Hardships from the Economic Reforms in Russia

The Shock Therapy Reforms were implemented with little concern with due process and the suffering of people. State industry collapsed. Many people lost their jobs, were not paid and saw the real value of their earnings plummet while the so-called oligarchs (tycoons) appeared seemingly out of nowhere to plunder institutions that had value. There was also hyperinflation, gangsterism, corruption, currency runs, capital flight, desperate poverty, increased alcoholism, declining health, and vulgar and wasteful displays of wealth by the super rich.

Overnight pensioners lost money that was expected to see them through their old age. Professors and military offices, people who would have had good lives in the Soviet system, earn piddlingly small salaries. Particularly hard hit were people that went to work in Siberia, the Far east and the Russian Arctic for triple wages and suddenly found themselves with no saving and not enough food to feed themselves and their families. There were even reports of unpaid workers collapsing in streets from hunger and people freezing to death because they couldn’t afford to heat their homes.

One Russian man, who retired at the age of 50, was forced to start working again after inflation robbed him of his pension. When a journalist told him the retirement age in America was 65 he shrugged. "Too late for us. In Russia we're dead by 65. You should have bought Kamchatka from us when you bought Alaska!" A Moscow teacher told National Geographic, "The rich get richer and the rest of us tread water or drown. I work much harder than I did in the old days, and sometimes that makes it hard to remember what we've gained. Freedom is sweet, but it's also a heavy, heavy load."

While the reforms helped increase the availability of a wider range of goods they did not create a free market but rather a system of state capitalism in which a confederation of bureaucrats, gangsters and politicians were able to privatize the most profitable wings of the Soviet Union's economy into their own hands. One often told joke went: Everything the Communists told us about communism was a complete lie. Unfortunately, everything they said about capitalism was also true. Still the Russians survived as they did in World War II and during the Stalin years. When asked what they thought of the economic break down a typical response was "Everything has collapsed—so what?" [Source: Mike Edwards, National Geographic, March 1993]

Monetary and Fiscal Policies Under Yeltsin

In 1992 and 1993, the Russian government expanded the money supply and credits at explosive rates that led directly to high inflation and to a deterioration in the exchange rate of the ruble. In January 1992, the Government clamped down on money and credit creation at the same time that it lifted price controls. However, beginning in February the RCB loosened the reins on the money supply. In the second and third quarters of 1992, the money supply had increased at especially sharp rates of 34 and 30 percent, respectively, and by the end of 1992, the Russian money supply had increased by eighteen times. [Source: Library of Congress, July 1996 *]

The sharp increase in the money supply was influenced by large foreign currency deposits that state-run enterprises and individuals had built up and by the depreciation of the ruble. Enterprises drew on these deposits to pay wages and other expenses after the Government had tightened restrictions on monetary emissions. Commercial banks monetized enterprise debts by drawing down accounts in foreign banks and drawing on privileged access to accounts in the RCB.*

Government efforts to control credit expansion also proved ephemeral in the early years of the transition. Domestic credit increased about nine times between the end of 1991 and 1992. The credit expansion was caused in part by the buildup of interenterprise arrears and the RCB's subsequent financing of those arrears. The Government restricted financing to state enterprises after it lifted controls on prices in January 1992, but enterprises faced cash shortages because the decontrol of prices cut demand for their products. Instead of curtailing production, most firms chose to build up inventories. To support continued production under these circumstances, enterprises relied on loans from other enterprises. By mid-1992, when the amount of unpaid interenterprise loans had reached 3.2 trillion rubles (about $20 billion), the government froze interenterprise debts. Shortly thereafter, the government provided 181 billion rubles (about $1.1 billion) in credits to enterprises that were still holding debt.*

The Government also failed to constrain its own expenditures in this period, partially under the influence of the conservative Supreme Soviet, which encouraged the Soviet-style financing of favored industries. By the end of 1992, the Russian budget deficit was 20 percent of GDP, much higher than the 5 percent projected under the economic program and stipulated under the International Monetary Fund (IMF--) conditions for international funding. This budget deficit was financed largely by expanding the money supply. These ill-advised monetary and fiscal policies resulted in an inflation rate of over 2,000 percent in 1992.*

End of Price Controls and Hyper Inflation in the Early 1990s

In January 1992, the government ended price controls without developing a competitive economy. The result was 2,520 percent inflation in 1992, the first year of economic reform. Ordinary Russians saw their savings vaporize, their salaries crash and the cost of ordinary items like eggs and chickens costing a month's salary. When state controls were lifted, the prices for basic foods like bread and butter shot up as much as 500 percent in a matter off days. The inflation rate was higher than 100 percent a month. It was 245 percent in January 1992. [Source: Mike Edwards, National Geographic, March 1993 ♠]

Inflation increased as money was printed to pay the subsidies to keep inefficient industries going. Food prices increased 25 fold in 1992 and 10 fold in 1993. Russian industry couldn't compete with foreign products and meet consumer demand for goods and services . Shops had more goods but people couldn't afford them. Banks hoarded cash for wage payments.

Inflation was reigned in as subsidies and government spending was reduced. By 1993 the annual rate had declined to 840 percent, still a very high figure. In 1994 the inflation rate had improved to 224 percent. Trends in annual inflation rates masked variations in monthly rates, however. In 1994, for example, the Government managed to reduce monthly rates from 21 percent in January to 4 percent in August, but rates climbed once again, to 16.4 percent by December and 18 percent by January 1995. Instability in Russian monetary policy caused the variations. [Source: Library of Congress, July 1996 *]

After tightening the flow of money early in 1994, the Government loosened its restrictions in response to demands for credits by agriculture, industries in the Far North, and some favored large enterprises. In 1995 the pattern was avoided more successfully by maintaining the tight monetary policy adopted early in the year and by passing a relatively stringent budget. Thus, the monthly inflation rate held virtually steady below 5 percent in the last quarter of the year. For the first half of 1996, the inflation rate was 16.5 percent. However, experts noted that control of inflation was aided substantially by the failure to pay wages to workers in state enterprises, a policy that kept prices low by depressing demand. *

Changes in Russian Exchange Rates

An important symptom of Russian macroeconomic instability was severe fluctuations in the exchange rate of the ruble. From July 1992, when the ruble first could be legally exchanged for United States dollars, to October 1995, the rate of exchange between the ruble and the dollar declined from 144 rubles per $1 to around 5,000 per $1. Prior to July 1992, the ruble's rate was set artificially at a highly overvalued level. But rapid changes in the nominal rate (the rate that does not account for inflation) reflected the overall macroeconomic instability. The most drastic example of such fluctuation was the Black Tuesday (1994) 27 percent reduction in the ruble's value. In July 1992, 5,000 rubles was worth $40 but five months later it was worth only $12. [Source: Library of Congress, July 1996 *]

In July 1995, the RCB announced its intention to maintain the ruble within a band of 4,300 to 4,900 per $1 through October 1995, but it later extended the period to June 1996. The announcement reflected strengthened fiscal and monetary policies and the buildup of reserves with which the Government could defend the ruble. By the end of October 1995, the ruble had stabilized and actually appreciated in inflation-adjusted terms. It remained stable during the first half of 1996. In May 1996, a "crawling band" exchange rate was introduced to allow the ruble to depreciate gradually through the end of 1996, beginning between 5,000 and 5,600 per $1 and ending between 5,500 and 6,100.*

Another sign of currency stabilization was the announcement that effective June 1996, the ruble would become fully convertible on a current-account basis. This meant that Russian citizens and foreigners would be able to convert rubles to other currencies for trade transactions.*

Politics During the Hyperinflation Period

In late 1992, deteriorating economic conditions and a sharp conflict with the parliament led Yeltsin to dismiss economic reform advocate Yegor Gaydar as prime minister. Gaydar's successor was Viktor Chernomyrdin, a former head of the State Natural Gas Company (Gazprom), who was considered less favorable to economic reform. Chernomyrdin formed a new government with Boris Fedorov, an economic reformer, as deputy prime minister and finance minister. Fedorov considered macroeconomic stabilization a primary goal of Russian economic policy. In January 1993, Fedorov announced a so-called anticrisis program to control inflation through tight monetary and fiscal policies. Under the program, the Government would control money and credit emissions by requiring the RCB to increase interest rates on credits by issuing government bonds, by partially financing budget deficits, and by starting to close inefficient state enterprises. Budget deficits were to be brought under control by limiting wage increases for state enterprises, by establishing quarterly budget deficit targets, and by providing a more efficient social safety net for the unemployed and pensioners. [Source: Glenn E. Curtis, Library of Congress, July 1996 *]

The printing of money and domestic credit expansion moderated somewhat in 1993. In a public confrontation with the parliament, Yeltsin won a referendum on his economic reform policies that may have given the reformers some political clout to curb state expenditures. In May 1993, the Ministry of Finance and the RCB agreed to macroeconomic measures, such as reducing subsidies and increasing revenues, to stabilize the economy. The RCB was to raise the discount lending rate to reflect inflation. Based on positive early results from this policy, the IMF extended the first payment of $1.5 billion to Russia from a special Systemic Transformation Facility (STF) the following July.*

Fedorov's anticrisis program and the Government's accord with the RCB had some effect. In the first three quarters of 1993, the RCB held money expansion to a monthly rate of 19 percent. It also substantially moderated the expansion of credits during that period. The 1993 annual inflation rate was around 1,000 percent, a sharp improvement over 1992, but still very high. The improvement figures were exaggerated, however, because state expenditures had been delayed from the last quarter of 1993 to the first quarter of 1994. State enterprise arrears, for example, had built up in 1993 to about 15 trillion rubles (about $13 billion, according to the mid-1993 exchange rate).*

In June 1994, Chernomyrdin presented a set of moderate reforms calculated to accommodate the more conservative elements of the Government and parliament while placating reformers and Western creditors. The prime minister pledged to move ahead with restructuring the economy and pursuing fiscal and monetary policies conducive to macroeconomic stabilization. But stabilization was undermined by the RCB, which issued credits to enterprises at subsidized rates, and by strong pressure from industrial and agricultural lobbies seeking additional credits.*

By October 1994, inflation, which had been reduced by tighter fiscal and monetary policies early in 1994, began to soar once again to dangerous levels. On October 11, a day that became known as Black Tuesday, the value of the ruble on interbank exchange markets plunged by 27 percent. Although experts presented a number of theories to explain the drop, including the existence of a conspiracy, the loosening of credit and monetary controls clearly was a significant cause of declining confidence in the Russian economy and its currency.*

Tight Money Policy and the Ending of Hyperinflation

In late 1994, Yeltsin reasserted his commitment to macroeconomic stabilization by firing Viktor Gerashchenko, head of the RCB, and nominating Tat'yana Paramonova as his replacement. Although reformers in the Russian government and the IMF and other Western supporters greeted the appointment with skepticism, Paramonova was able to implement a tight monetary policy that ended cheap credits and restrained interest rates (although the money supply fluctuated in 1995). Furthermore, the parliament passed restrictions on the use of monetary policy to finance the state debt, and the Ministry of Finance began to issue government bonds at market rates to finance the deficits. [Source: Glenn E. Curtis, Library of Congress, July 1996 *]

The Government also began to address the interenterprise debt that had been feeding inflation. The 1995 budget draft, which was proposed in September 1994, included a commitment to reducing inflation and the budget deficit to levels acceptable to the IMF, with the aim of qualifying for additional international funding. In this budget proposal, the Chernomyrdin government sent a signal that it no longer would tolerate soft credits and loose budget constraints, and that stabilization must be a top government priority.*

During most of 1995, the government maintained its commitment to tight fiscal constraints, and budget deficits remained within prescribed parameters. However, in 1995 pressures mounted to increase government spending to alleviate wage arrearages, which were becoming a chronic problem within state enterprises, and to improve the increasingly tattered social safety net. In fact, in 1995 and 1996 the state's failure to pay many such obligations (as well as the wages of most state workers) was a major factor in keeping Russia's budget deficit at a moderate level. Conditions changed by the second half of 1995. The members of the State Duma (beginning in 1994, the lower house of the Federal Assembly, Russia's parliament) faced elections in December, and Yeltsin faced dim prospects in his 1996 presidential reelection bid. Therefore, political conditions caused both Duma deputies and the president to make promises to increase spending.*

In addition, late in 1995 Yeltsin dismissed Anatoliy Chubais, one of the last economic reform advocates remaining in a top Government position, as deputy prime minister in charge of economic policy. In place of Chubais, Yeltsin named Vladimir Kadannikov, a former automobile plant manager whose views were antireform. This move raised concerns in Russia and the West about Yeltsin's commitment to economic reform. Another casualty of the political atmosphere was RCB chairman Paramonova, whose nomination had remained a source of controversy between the State Duma and the Government. In November 1995, Yeltsin was forced to replace her with Sergey Dubinin, a Chernomyrdin protégé who continued the tight-money policy that Paramonova had established.*

By mid-1996 many Duma deputies raised concerns about the Government's failure to meet its tax revenue targets. Revenue shortages were blamed on a number of factors, including a heavy tax burden that encourages noncompliance and an inefficient and corrupt tax collection system. A variety of tax collection reforms were proposed in the parliament and the Government, but by 1996 Russian enterprises and regional authorities had established a strong pattern of noncompliance with national tax regulations, and the Federal Tax Police Service was ineffectual in apprehending violators.*

State of the Russian Economy Under Yeltsin

The result of Yeltsin’s economic reform was mixed. On one hand Russia made great strides toward developing a market economy by implanting basic tenets such as market-determined prices. Critical elements such as privatization of state enterprises and extensive foreign investment went into place in the first few years of the post-Soviet period. But other fundamental parts of the economic infrastructure, such as commercial banking and authoritative, comprehensive commercial laws, were absent or only partly in place by 1996. Although by the mid-1990s a return to Soviet-era central planning seemed unlikely, the configuration of the post-transition economy remained unpredictable.* [Source: Library of Congress, July 1996 *]

Under Yeltsin, the economy was dominated by insiders and operated under a system of bribery and coercion. Yeltsin didn’t seem to know a whole lot about economics and relied on his advisors to tell him what to do and thus his policies were defined by whoever his advisors were at the time. Yeltsin was described as on-again off-again reformer. He was infamous for issuing multiple and contradictory decrees "like a drunken sailor." Important tax, customs and investment rules appeared to be made on a whim and altered for no apparent reason just as everyone was getting used to them. Unfortunately, his leadership encouraged inefficiency and corruption more than wealth and prosperity. Yeltsin’s economic reforms were also slowed by contradictory legislation passed by hardliners and Communists in parliament. Yeltsin was forced to water down proposed reforms and make compromises, which took the steam out the reform efforts.

Positive economic news in 1997 towards the end of Yeltsin’s tenure included the continuing reduction of inflation, which reached an annual rate of 14.5 percent in June--the lowest rate since Russia's independence. Also, the reorganization of the Government in March caused the IMF to resume monthly payments on Russia's $10 billion loan, which had been suspended. The World Bank also announced a two-year loan of $6 billion to help pay overdue wages and pensions. April Yeltsin renewed his appeal for Russia's consumers to "buy Russian" to support the domestic economy in the face of increased consumption of imported consumer goods. However, Russian manufacturers faced a circular dilemma: consistently low quality kept the demand for Russian goods from expanding, but firms were unable to improve quality without new profits or increasingly scarce government subsidies. *

Economic Problems Under Yeltsin

The overall economic situation continued to be overshadowed by the Government's inability to balance its budget. Continuing its effort to improve tax collection--the most often cited way of paying overdue state salaries and pensions--in his government submitted a new tax code to the State Duma for approval. Under Yeltsin's implicit threat to dissolve the Duma, the body gave preliminary approval. Meanwhile, major enterprises continued to avoid full tax payment. According to an April 1997 State Taxation Service report, Gazprom, the natural gas monopoly, used 140 separate bank accounts to shelter its assets. Of the Government's list of eighty leading tax-evading enterprises, fifty-three were in the fuel and energy industry. [Source: Glenn E. Curtis, Library of Congress, July 1996 *]

Only 57 percent of projected revenues were collected in the first quarter of 1997, leaving arrears of $12 billion, and only 63 percent of budgeted expenditures were made. By May the Government owed an estimated $2.2 billion in pensions, $2.3 billion in wages to state workers, and $1.4 billion in child support allowances. The shortfall also reduced economic investment, which in the first half of 1997 was only about 95 percent of the amount invested in the same period of 1996. *

In response to the shortfall, Minister of Finance Anatoliy Chubais submitted a proposal to the State Duma for sequestration of allotted funds, warning that the Government could not continue functioning if major cuts were not made. The revisions called for reducing spending by $19 billion. Despite strong and widespread opposition to the level and allocation of the cuts, in June the Duma adjourned for its summer vacation without submitting an alternative plan. *

Meanwhile, the "capital flight" of hard currency from Russia continued at a rapid rate in 1997. International police authorities estimated that $1 to $2 billion dollars left the country every month, much of it connected with illegal activity and invested abroad by Russian émigrés. Experts identified this trend as a sign of continuing low confidence in the domestic economy. *

For the first six months of 1997, Russia's GDP shrank by 0.2 percent, casting doubt on Yeltsin's July assertion that the economy had "turned the corner."

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Text Sources: New York Times, Washington Post, Los Angeles Times, Times of London, Lonely Planet Guides, Library of Congress, U.S. government, Compton’s Encyclopedia, The Guardian, National Geographic, Smithsonian magazine, The New Yorker, Time, Newsweek, Reuters, AP, AFP, Wall Street Journal, The Atlantic Monthly, The Economist, Foreign Policy, Wikipedia, BBC, CNN, and various books, websites and other publications.

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© 2008 Jeffrey Hays

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