Jenny Yang David Hauge

“Russian reformers, placing too much faith in the free market, gave too little attention to government’s role”

December 25 th, 1991: Gorbachev resigns as USSR president December 31 st, 1991: Soviet Union officially dissolved Post-Soviet Russia  Boris Yeltsin becomes president - elected June 1991  Soviet Administrative Command system needs restructuring  Within days of dissolution, Yeltsin employs program known as “Shock Therapy”

“Shock Therapy” (1) Liberalization – provides freedom (2) Privatization – provides incentives (3) Stabilization - provides the environment so that private enterprises can thrive

Soviet Command System Government determined prices Firms produce what government authorities decide Relied on government oversight to curb malfeasance and incompetence Market determined prices Firms produce to maximize profit Relies on market competition to curb malfeasance and incompetence Free Market System

Competitive-equilibrium model  Consumers selfishly maximize utility  Firms maximize profit  Prices adjust to ensure supply-demand equilibrium Three essential elements  Market-determined prices  Profit maximization  Competitive markets

Belief:  Resources allocate efficiently and create prosperity  Three elements would emerge spontaneously once the command system was terminated  If there is a problem, it is because the government is intruding Primary challenge:  Keep government out of the economy

Results:  Industry stunned  Steep drop in living standards  Transfer of wealth  Corruption  Collapse of Investment Realization:  Government necessary in multiple roles

In the Soviet era, prices poorly reflected economic cost  False assumption: Decontrolling prices would allow Russian economy to leap forward Price controls removed on January 2 nd, 1992  Inventory reappeared on store shelves  Price increases were enormous  Industry hobbled  government revenue fell Importance of government  Price regulation merits a restrain on inflation, slows change in the price structure, and is imperative for monopolies

In the 1960’s, Soviets increase enterprise autonomy  Began using profit as a measure of performance  But, other two essential elements absent During Shock Therapy, there was a struggle for control over previously state-owned enterprises and their assets  Costly paternalistic practices  Autonomous profit-maximizing firms, even in competitive markets, don’t automatically serve the public interest Importance of government  Suitable institutions necessary to channel profit maximization and serve the public interest

In Soviet economy, there were no wholesalers to provide backup inventory, products supplied by monopolies Hope that with Shock Therapy, competitive markets would emerge overnight  Instead, organize crime and anticompetitive structures evolved, controlled by oligarchs Importance of government  Encourage growth of wholesalers and middlemen and protect them from criminal infiltration  Dismantle monopolies and disallow mergers that would reduce competition  Minimize licensing requirements and open economy to capital inflows

Transition is about change, equilibrium is inherently static Government initiatives needed to address:  Change  Criminalization  De facto colonization  Inequality Institutional framework needs to be sound

Absence leads to uncooperative behavior, criminalization and social disorder Only government can:  Define property rights  Provide genuine security for private property  Ensure enforcement of contracts without violence Formation is a gradual process Regard for common good is vital

Escalating corruption and economic inequality  Demand decreased Inflation Supply channels were disrupted Ruble appreciated dramatically  Russian products less competitive  Fear of collapse in the exchange rate  Further erosion of demand

Defined: Government intervention to foster development of particular sectors of the economy Conflicts liberalization-privatization-stabilization requirements of transition But, virtually all successful modern economies have relied upon government intervention to support industrialization (U.S., Germany, Japan, China, etc.) Provides assistance in the short run so that industry can be internationally competitive in the long run Simple empirical model suggested: Four Spheres  Directs attention to actual economic conditions

Largest of the four: accounts for 40% of employment Demise under competitive-equilibrium model Market discipline, even if improved, won’t revitalize Government intervention:  Don’t revive firms lacking potential  Facilitate movement of labor and capital to lawful, dynamic businesses  Intelligent industrial policy also needed

Essential issue: who benefits from nation’s wealth? Under CE model, private ownership is superior  Government doesn’t capture gains Oil production fell in 1990’s as investment declined  Foreign companies offered technology and finance  Russian capitalists reluctant, didn’t want to lose control Gazprom Government monitoring and control is required to tax fully the economic rents from natural resources

33% of employment Importance of government in formative stages of transition Dependence on low-cost transportation and communication Banks Other public services:  Health care  Education  Law, public safety and environmental protection

Most relevant to CE model, appropriate for government to be more limited Obstruction by control over housing  Do need to curb crime Decrease in formation of new businesses, attributed to mafia intervention  Extortion  Intimidation of competitors  Bribery

Limiting government is consequential for growth of sphere four However, deliberate government action required in other three spheres Since they are intertwined, improved conditions in any one inevitably benefit the others  Sphere two delivers financial resources to sphere three  In turn, providing lawful economic environment and functional market institutions essential for sphere one and the rest of the economy “A government program responsive to all spheres would build market institutions, maintain aggregate demand for Russian goods and provide judicious support for economic development.”

Clifford Gaddy and Barry Ickes “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.” Table

Basically, this economy has arisen for two reasons:  Most of the Russian economy takes away value  Most participants pretend that it doesn’t