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The Times

Russian people paid the price for shock therapy. By Joseph Stiglitz. June 22, 2002

WITH the collapse of communism the challenges facing the economies of the nations of the former Soviet Union were daunting. They had to move from one price system — the distorted price system that prevailed under communism — to a market price system; they had to create markets and the institutional infrastructure that underlies it; and they had to privatise all the property which previously had belonged to the State. They had to create a new kind of entrepreneurship — not just the kind that was good at circumventing government rules and laws — and new enterprises to help to redeploy the resources that had previously been so efficiently used.

No matter how one looked at it, these economies faced hard choices, and there were fierce debates about which choices to make. The most contentious centred on the speed of reform: some experts worried that if they did not privatise quickly, creating a large group of people with a vested interest in capitalism, there would be a reversion to communism. But others worried that if they moved too quickly, the reforms would be a disaster — economic failures compounded by political corruption — opening up the way to a backlash, either from the extreme left or right. The former school was called “shock therapy”, the latter “gradualist”.

The views of the shock therapists — strongly advocated by the US Treasury and the IMF — prevailed in most of the countries. The gradualists, however, believed that the transition to a market economy would be better managed by moving at a reasonable speed, in good order. Ten years later, the wisdom of the gradualist approach is at last being recognised: the tortoises have overtaken the hares. The gradualist critics of shock therapy not only accurately predicted its failures but also outlined the reasons why it would not work. Their only failure was to underestimate the magnitude of the disaster.

The first mistakes occurred almost immediately as the transition began. In the enthusiasm to get on with a market economy, most prices were freed overnight in 1992, setting in motion an inflation that wiped out savings. Everybody recognised that with hyperinflation (inflation at double-digit rates per month), it would be difficult to have a successful transition. Thus, the first round of shock therapy — instantaneous price liberalisation — necessitated the second round: bringing inflation down. This entailed tightening monetary policy — raising interest rates.

While most of the prices were completely freed, some of the most important prices were kept low — those for natural resources. With the newly declared “market economy,” this created an open invitation: If you can buy, say, oil and resell it in the West, you could make millions or even billions of dollars. So people did. Instead of making money by creating new enterprises, they got rich from a new form of the old entrepreneurship — exploiting mistaken government policies.

Rapid privatisation was the third pillar of the radical reform strategy. But the first two pillars put obstacles in the way of the third. The initial high inflation had wiped out the savings of most Russians so there were not enough people in the country who had money to buy the enterprises being privatised. Even if they could afford to buy the enterprises, it would be difficult to revitalise them, given the high interest rates and lack of financial institutions to provide capital.

Gross domestic product in post-1989 Russia fell, year after year. What had been envisioned as a short transition recession turned into one of a decade or more. The bottom never seemed to be in sight. Privatisation accompanied by the opening of the capital markets, led not to wealth creation but to asset stripping. It was perfectly logical. An oligarch who has just been able to use political influence to garner assets worth billions, after paying only a pittance, would naturally want to get his money out of the country. Keeping money in Russia meant investing it in a country in deep depression, and risking not only low returns but having the assets seized by the next government, which would inevitably complain, quite rightly, about the “illegitimacy” of the privatisation process. Anyone smart enough to be a winner in the privatisation sweepstakes would be smart enough to put their money in the booming US stock market, or into the safe haven of secretive offshore bank accounts. It was not even a close call; and not surprisingly, billions poured out of the country.

Thus, at the time of the East Asia crisis, Russia was in a peculiar position. It had an abundance of natural resources, but its Government was poor. The Government was virtually giving away its valuable state assets, yet it was unable to provide pensions for the elderly or welfare payments. The Government was borrowing billions from the IMF, becoming increasingly indebted, while the oligarchs, who had received such largesse from the Government, were taking billions out of the country. The IMF had encouraged the Government to open up its capital accounts, allowing a free flow of capital. The policy was supposed to make the country more attractive for foreign investors; but it was virtually a one-way door that facilitated a rush of money out of the country.

Because the country was deeply in debt, the higher interest rates that the East Asia crisis provoked created an enormous additional strain. This rickety tower collapsed when oil prices fell. Due to recessions and depressions in South-East Asia, which IMF policies had exacerbated, oil demand not only failed to expand as expected but actually contracted. The resulting imbalance between demand and supply of oil turned into a dramatic fall in crude oil prices (down 40 per cent in the first six months of 1998 compared with the average prices in 1997). Oil is both a major export commodity and a source of government tax revenue for Russia, and the drop in prices had a predictably devastating effect. Given the exchange rate at the time, Russia’s oil industry had almost ceased.

It was clear that the rouble was overvalued. This — combined with the other macroeconomic policies foisted on the country by the IMF — had crushed the economy, and while the official unemployment rate remained subdued, there was massive disguised unemployment. The managers of many firms were reluctant to fire workers, given the absence of an adequate safety net. Though unemployment was disguised, it was no less traumatic: while workers only pretended to work, the firms only pretended to pay. Wage payments fell into massive arrears, and when workers were paid, it was often with bartered goods rather than roubles.

Despite this suffering on the part of the majority of Russians, the reformers and their adviser in the IMF feared a devaluation, believing that it would set off another round of hyperinflation. By May 1998, it was clear Russia would need outside assistance to maintain its exchange rate. In the belief that a devaluation was inevitable, domestic interest rates soared and more money left the country as people converted their roubles for dollars. Because of this fear of holding roubles, and the lack of confidence in the Government’s ability to repay its debt, by June 1998 the Government had to pay almost 60 per cent interest rates on its rouble loans. That figure soared to 150 per cent in weeks.

The crisis mounted in the way that these crises so frequently do. Speculators could see how much in the way of reserves was left, and as reserves dwindled, betting on a devaluation became increasingly a one-way bet.

When the crisis hit, the IMF led the rescue efforts, but it wanted the World Bank to provide $6 billion of the rescue package. The total rescue package was for $22.6 billion. The IMF would provide $11.2 billion of this total, the World Bank $6 billion, and the rest would be provided by the Japanese Government.

This was hotly debated inside the World Bank. There were many of us who had been questioning lending to Russia all along. We questioned whether the benefits to possible future growth were large enough to justify loans that would leave a legacy of debt. Many thought that the IMF was making it easier for the Government to put off meaningful reforms, such as collecting taxes from the oil companies. The evidence of corruption in Russia was clear. The Bank’s own study of corruption had identified that region as among the most corrupt in the world. The West knew that much of those billions would be diverted from their intended purposes to the families and associates of corrupt officials and their oligarch friends. While the Bank and the IMF had seemingly taken a strong stance against lending to corrupt governments, it appeared that there were two standards. Small non-strategic countries such as Kenya were denied loans because of corruption, while countries such as Russia, where the corruption was on a far larger scale, were continually lent money.

Apart from these moral issues, there were straightforward economic issues. The IMF’s bailout money was supposed to be used to support the exchange rate. However, if a country’s currency is overvalued and this causes the country’s economy to suffer, maintaining the exchange rate makes little sense. If the exchange rate support works, the country suffers. But in the more likely case that the support does not work, the money is wasted, and the country is deeper in debt. Our calculations showed that Russia’s exchange rate was overvalued, so providing money to maintain that exchange rate was simply bad economic policy. Moreover, calculations at the World Bank before the loan was made, based on estimates of government revenues and expenditures over time, strongly suggested that the July 1998 loan would not work. Unless a miracle brought interest rates down drastically, by the time autumn rolled around, Russia would be back in crisis.

In spite of strong opposition from its own staff, the Bank was under enormous political pressure from the Clinton Administration to lend money to Russia. The Bank managed a compromise, publicly announcing a very large loan, but providing the loan in tranches — instalments. A decision was made to make $300 million available immediately, with the rest available only later, as we saw how Russia’s reforms progressed. Most of us thought that the programme would fail long before the additional money had to be forthcoming. Our predictions proved correct. Remarkably, the IMF seemed able to overlook the corruption, and the attendant risks with what would happen with the money. It actually thought that maintaining the exchange rate at an overvalued level was a good thing, and that the money would enable it to do this for more than a couple of months. It poured billions into the country.

Three weeks after the loan was made, Russia announced a unilateral suspension of payments and a devaluation of the rouble. The rouble crashed. By January 1999, the rouble had declined in real effective terms by more than 45 per cent from its July 1998 level. It was the start of a global financial crisis. Interest rates to emerging markets soared. Even developing countries that had been pursuing sound economic policies found it impossible to raise funds. Brazil’s recession deepened, and eventually it too faced a currency crisis. Argentina and other Latin American countries only gradually recovering from previous crises were again pushed near the brink.

The surprise about the collapse was not the collapse itself, but the fact that it really did take IMF officials by surprise. They had genuinely believed that their programme would work. Our World Bank forecasts proved only partially correct: we thought that the money might sustain the exchange rate for three months; it lasted three weeks. We felt that it would take days or even weeks for the oligarchs to bleed the money out of the country; it took merely hours and days. The Russian Government even “allowed” the exchange rate to appreciate. This meant the oligarchs needed to spend fewer roubles to purchase their dollars. The IMF would have made life easier all around if it had simply sent the money directly into the Swiss and Cypriot bank accounts.

It was, of course, not just the oligarchs who benefited from the rescue. The Wall Street and other Western investment bankers, who had been among those pressing the hardest for a rescue package, knew it would not last: they too took the short respite provided by the rescue to rescue as much as they could, to flee the country with whatever they could salvage.

By lending Russia money for a doomed cause, IMF policies led Russia into deeper debt, with nothing to show for it. The cost of the mistake was not borne by the IMF officials who gave the loan, or America who pushed for it, or the Western bankers and the oligarchs who benefited from the loan, but by the Russian taxpayer.

There was one positive aspect of the crisis: the devaluation spurred Russia’s import competing sectors — goods actually produced in Russia finally took a growing share of the home market. This “unintended consequence” ultimately led to the long-awaited growth in Russia’s real (as opposed to black) economy.

Globalisation and its Discontents by Joseph Stiglitz is published by Allen Lane on July 4.