East Asia Crisis
Who Lost Russia?

excerpted from the book

Globalization and Its Discontents

by Joseph E. Stiglitz

WW Norton, 2003, paper

when the Thai baht collapsed on July 2, 1997, no one knew that this was the beginning of the greatest economic crisis since the Great Depression-one that would spread from Asia to Russia and Latin America and threaten the entire world. For ten years the baht had traded at around 25 to the dollar; then overnight it fell by about 25 percent. Currency speculation spread and hit Malaysia, Korea, the Philippines, and Indonesia, and by the end of the year what had started as an exchange rate disaster threatened to take down many of the region's banks, stock markets, and even entire economies. The crisis is over now, but countries such as Indonesia will feel its effects for years.

The social and political consequences of mishandling the Asian crisis may never be measured fully. When the IMF's managing director Michel Camdessus, and G-22 finance ministers and central bank governors (the finance ministers and central bank governors from the major industrial countries, plus the major Asian economies, including Australia) met in Kuala Lumpur, Malaysia, in early December 1997, I warned of the danger of social and political unrest, especially in countries where there has been a history of ethnic division (as in Indonesia, where there had been massive ethnic rioting some thirty years earlier), if the excessively contractionary monetary and fiscal policies that were responded that they being imposed continued. Camdessus calmly needed to follow Mexico's example; they had to take the painful measures if they were to recover. Unfortunately, my forecasts turned out to be all too right. Just over five months after I warned of the impending disaster, riots broke out. While the IMF had provided some X23 billion to be used to support the exchange rate and bail out creditors, the far, far smaller sums required to help the poor were not forthcoming. In American parlance, there were billions and billions for corporate welfare, but not the more modest millions for welfare for ordinary citizens. Food and fuel subsidies for the poor in Indonesia were drastically cut back, and riots exploded the next day. As had happened thirty years earlier, the Indonesian businessmen and their families became the victims.

It was not just that IMF policy might be regarded by soft-headed liberals as inhumane. Even if one cared little for those who faced starvation, or the children whose growth would be stunted by malnutrition, it was simply bad economics. Riots do not restore business confidence They drive capital out of a country; they do not attract capital into a country. And riots are predictable-like any social phenomenon, not with certainty, but with a high probability. It was clear Indonesia was ripe for such social upheaval. The IMF itself should have known this; around the world, the IMF has inspired riots when its policies cut off food subsidies.

After the riots in Indonesia, the IMF reversed its position; food subsidies were restored. But again, the IMF showed that it had not learned the basic lesson of "irreversibility." Just as a firm that was bankrupted by the high interest rates does not become "un-bankrupted" when the interest rates were lowered, a society that is rendered asunder by riots induced by cutting out food subsides just as it is plunging into depression is not brought together when the food subsidies are restored. Indeed, in some quarters, the bitterness is all the greater: if the food subsidies could have been afforded, why were they taken away in the first place?

I had the opportunity to talk to Malaysia's prime minister after the riots in Indonesia. His country had also experienced ethnic riots in the past. Malaysia had done a lot to prevent their recurrence, including putting in a program to promote employment for ethnic Malays. Mahathir knew that all the gains in building a multiracial society could be lost, had he let the IMF dictate its policies to him and his country and then riots had broken out. For him, preventing a severe recession was not just a matter of economics, it was a matter of the survival of the nation.

With the fall of the Berlin Wall in late 1989, one of the most important economic transitions of all time began. It was the second bold economic and social experiment of the century. The first was Russia's transition to communism seven decades earlier. Over the years, the failures of this first experiment became apparent. As a consequence of the 1917 Revolution and the Soviet hegemony over a large part of Europe after World War II, some 8 percent of the world's population that lived under the Soviet Communist system forfeited both political freedom and economic prosperity. The second transition in Russia as well as in Eastern and Southeastern Europe is far from over, but this much is clear: in Russia it has fallen far short of what the advocates of the market economy had promised, or hoped for. For the majority of those living in the former Soviet Union, economic life under capitalism has been even worse than the old Communist leaders had said it would be. Prospects for the future are bleak. The middle class has been devastated, a system of crony and mafia capitalism has been created, and the one achievement, the creation of a democracy with meaningful freedoms, including a free press, appears fragile at best, particularly as formerly independent TV stations are shut down one by one. While those in Russia must bear much of the blame for what has happened, the Western advisers, especially from the United States and the IMF, who marched in so quickly to preach the gospel of the market economy, must also take some blame. At the very least, they provided support to those who led Russia and many of the other economies down the paths they followed, arguing for a new religion-market fundamentalism-as a substitute for the old one-Marxism-which j had proved so deficient.


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, and moved the problem of macrostability to the top of the agenda. Everybody recognized 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 liberalization-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. And it was this "rent-seeking" behavior that would provide the basis of the claim by reformers that the problem was not that the reforms had been too quick, but that they had been too slow. If only all prices had been freed immediately! There is considerable validity in this argument, but as a defense of the radical reforms it is disingenuous. Political processes never give the technocrat free rein, and for good reason: as we have seen, technocrats often miss out on important economic, social, and political dimensions. Reform, even in well-functioning political and economic systems, is always "messy." Even if it made sense to push for instantaneous liberalization, the more relevant question is, how should one have proceeded with liberalization if one could not succeed in getting important sectors, like energy prices, liberalized quickly?

Liberalization and stabilization were two of the pillars of the radical reform strategy. Rapid privatization was the third. 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 the money to buy the enterprises being privatized. Even if they could afford to buy the enterprises, it would be difficult to revitalize them, given the high interest rates and lack of financial institutions to provide capital.

Privatization was supposed to be the first step in the process of restructuring the economy. Not only did ownership have to change but so did management; and production had to be reoriented, from producing what firms were told to produce to producing what consumers wanted. This restructuring would, of course, require new investment, and in many cases job cuts. Job cuts help overall efficiency, of course, only if they result in workers moving from low productivity jobs to high-productivity employment. Unfortunately, too little of this positive restructuring occurred, partly because the strategy put almost insurmountable obstacles in the way.

The radical reform strategy did not work: gross domestic product in Russia fell, year after year. What had been envisioned as a short transition recession turned into one of a decade or more. The bottom seemed never in sight. The devastation-the loss in GDP-was greater than Russia had suffered in World War II. In the period 194(}46 the Soviet Union industrial production fell 24 percent. In the period 199(}98, Russian industrial production fell 42.9 percent almost equal to the fall in GDP (45%).Those familiar with the history of the earlier transition in the Russian Revolution, into communism, could draw some comparisons between that socioeconomic trauma and the post-1989 transition: farm livestock decreased by half, investment in manufacturing came almost to a stop. Russia was able to attract some foreign investment in natural resources; Africa had shown long ago that if you price natural resources low enough, it is easy to attract foreign investment in them.

The stabilization/liberalization/privatization program was, of course, not a growth program. It was intended to set the preconditions for growth. Instead, it set the preconditions for decline. Not only was investment halted, but capital was used up-savings vaporized by inflation, the proceeds of privatization or foreign loans largely misappropriated. Privatization, 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 privatization process. Anyone smart enough to be a winner in the privatization sweepstakes would be smart enough to put their money in the booming U.S. 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.

The IMF kept promising that recovery was around the corner. By 1997, it had reason for this optimism. With output having already fallen 40 percent since 1990, how much further down could it go? Besides, the country was doing much of what the Fund had stressed. It had liberalized, if not completely; it had stabilized, if not completely (inflation rates were brought down dramatically); and it had privatized. But of course it is easy to privatize quickly, if one does not pay any attention to how one privatizes: essentially give away valuable state property to one's friends. Indeed, it can be highly profitable for governments to do so-whether the kickbacks come back in the form of cash payments or in campaign contributions (or both).

But the glimpses of recovery seen in 1997 were not to last long. Indeed, the mistakes the IMF made in a distant part of the world were pivotal. In 1998, the fallout from the East Asian crisis hit. The crisis had led to a general skittishness about investing in emerging markets, and investors demanded higher returns to compensate them for lending capital to these countries. Mirroring the weaknesses in GDP and investment were weaknesses in public finance: the Russian government had been borrowing heavily. Though it had difficulty making budget ends meet, the government, pressured by the United States, the World Bank, and the IMF to privatize rapidly, had turned over its state assets for a pittance, and done so before it had put in place an effective tax system. The government created a powerful class of oligarchs and businessmen who paid but a fraction of what they owed in taxes, much less what they would have paid in virtually any other 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 for the poor. 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.


Seldom has the gap between expectations and reality been greater than in the case of the transition from communism to the market. The combination of privatization, liberalization, and decentralization was supposed to lead quickly, after perhaps a short transition recession, to a vast increase in production. It was expected that the benefits from transition would be greater in the long run than in the short run, as old, inefficient machines were replaced, and a new generation of entrepreneurs was created. Full integration into the global economy, with all the benefits that would bring, would also come quickly, if not immediately.

These expectations for economic growth were not realized, not only in Russia but in most of the economies in transition. Only a few of the former Communist countries-such as Poland, Hungary, Slovenia, and Slovakia-have a GDP equal to that of a decade ago. For the rest, the magnitudes of the declines in incomes are so large that they are hard to fathom. According to World Bank data, Russia today (2000) has a GDP that is less than two-thirds of what it was in 1989. Moldova's decline is the most dramatic, with output today less than a third of what it was a decade ago. Ukraine's 2000 GDP is just a third of what it was ten years ago.

Underlying the data were true symptoms of Russia's malady. Russia had quickly been transformed from an industrial giant-a country that had managed with Sputnik to put the first satellite into orbit-into a natural resource exporter; resources, and especially oil and gas, accounted for over half of all exports. While the Western reform advisers were writing books with titles like The Coming Boom in Russia or How Russia Became a Market Economy, the data itself was making it hard to take seriously the rosy pictures they were painting, and more dispassionate observers were writing books like The Sale of the Century: Russia's Wild Ride from Communism to Capitalism.

The magnitude of GDP decline in Russia (not to mention other former Communist countries) is the subject of controversy, and some argue that because of the growing and critical informal sector-from street vendors to plumbers, painters, and other service providers, whose economic activities are typically hard to capture in national income statistics-the numbers represent an overestimate of the size of the decline. However, others argue that because so many of the transactions in Russia entail barter (over 50% of industrial sales),9 and because the "market" prices are typically higher than these "barter" prices, the statistics actually underestimate the decline.

Taking all this into account, there is still a consensus that most individuals have experienced a marked deterioration in their basic standard of living, reflected in a host of social indicators. While in the rest of the world life spans were increasing markedly, in Russia they were over three years shorter, and in Ukraine almost three years shorter. Survey data of household consumption-what people eat, how much they spend on clothing, and what type of housing they live in-corroborates a marked decline in standards of living, on par with those suggested by the fall in GDP statistics. Given that the government was spending less on defense, standards of living should have increased even more than GDP. To put it another way, assume that somehow previous expenditures on consumption could have been preserved, and a third of the expenditures on military could have been shifted into new production of consumption goods, and that there had been no restructuring to increase efficiency or to take advantage of the new trade opportunities. Consumption-living standards-would then have increased by 4 percent, a small amount but far better than the actual decline.

Increased Poverty and Inequality

These statistics do not tell the whole story of the transition in Russia. They ignore one of the most important successes: How do you value the benefits of the new democracy, as imperfect as it might be? But they also ignore one of the most important failures: The increase in poverty and inequality.

While the size of the national economic pie was shrinking, it was being divided up more and more inequitably so the average Russian was getting a smaller and smaller slice. In 1989, only 2 percent of those living in Russia were in poverty. By late 1998, that number had soared to 23.8 percent, using the $2 a day standard. More than 40 percent of the country had less than $4 a day, according to a survey conducted by the World Bank. The statistics for children revealed an even deeper problem, with more than 50 percent living in families in poverty. Other post-Communist countries have seen comparable, if not worse, increases in poverty.

Shortly after I arrived at the World Bank, I began taking a closer look at what was going on, and at the strategies that were being pursued. When I raised my concerns about these matters, an economist at the Bank who had played a key role in the privatizations responded heatedly. He cited the traffic jams of cars, many of them Mercedes, leaving Moscow on a summer weekend, and the stores filled with imported luxury goods. This was a far different picture from the empty and colorless retail establishments under the former regime. I did not disagree that a substantial number of people had been made wealthy enough to cause a traffic jam, or to create a demand for Gucci shoes and other imported luxury items sufficient for certain stores to prosper. At many European resorts, the wealthy Russian has replaced the wealthy Arab of two decades ago. In some, street signs are even given in Russian along with the native language. But a traffic jam of Mercedes in a country with a per capita income of $4,730 (as it was in 1997) is a sign of a sickness, not health. It is a clear sign of a society that concentrates its wealth among the few, rather than distributing it among the many.

While the transition has greatly increased the number of those in poverty, and led a few at the top to prosper, the middle class in Russia has perhaps been the hardest hit. The inflation first wiped out their meager savings, as we have seen. With wages not keeping up with inflation, their real incomes fell. Cutbacks in expenditures on education and health further eroded their standards of living. Those who could, emigrated. (Some countries, like Bulgaria, lost 10% or more of their population, and an even larger fraction of their educated workforce.) The bright students in Russia and other countries of the former Soviet Union that I've met work hard, with one ambition in mind: to migrate to the West. These losses are important not just for what they imply today for those living in Russia, but for what they portend for the future: historically, the middle class has been central to creating a society based on the rule of law and democratic values.

The magnitude of the increase in inequality, like the magnitude and duration of the economic decline, came as a surprise. Experts did expect some increase in inequality, or at least measured inequality. Under the old regime, incomes were kept similar by suppressing wage differences. The Communist system, while it did not make for an easy life, avoided the extremes of poverty, and kept living standards relatively equal, by providing a high common denominator of quality for education, housing, health care and child care services. With a switch to a market economy, those who worked hard and produced well would reap the rewards for their efforts, so some increase in inequality was inevitable. However, it was expected that Russia would be spared the inequality arising from inherited wealth. Without this legacy of inherited inequality, there was the promise of a more egalitarian market economy. How differently matters have turned out! Russia today has a level of inequality comparable with the worst in the world, those Latin American societies which were based on a semifeudal heritage.

Russia has gotten the worst of all possible worlds-an enormous decline in output and an enormous increase in inequality. And the prognosis for the future is bleak: extremes of inequality impede l growth, particularly when they lead to social and political instability.

One of the reasons that it is important to have an active and critical media is to ensure that the decisions that get made reflect not just the interests of a few but the general interest of society. It was essential for the continuation of the Communist system that there not be public scrutiny. One of the problems with the failure to create an effective, independent, and competitive media in Russia was that the policies-such as the loans-for-share scheme-were not subjected to the public critique that they deserved. Even in the West, however, the critical decisions about Russian policy, both at the international economic institutions and in the U.S. Treasury, went on largely behind closed doors. Neither the taxpayers in the West, to whom these institutions were supposed to be accountable, nor the Russian people, who paid the ultimate price, knew much about what was going on at the time. Only now are we wrestling with the question of "Who lost Russia?"-and why.

Globalization and Its Discontents

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