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
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 "REFORM" STORY
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
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.
THE FAILED TRANSITIONS
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
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.
and Its Discontents