The Times (UK)
http://www.timesonline.co.uk/article/0,,630-334118,00.html
June 22, 2002
Russian people paid the price for shock therapy
By Joseph Stiglitz
In the first of a two-part serialisation outspoken former chief
economist at the World Bank says misguided Western policies towards
Russia enriched the oligarchs at the expense of workers
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 at �16.99.
Serbian News Network - SNN
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