Tuesday, August 03, 2004

Is There Hope for Russia?

Things seem to be picking up for Russia, heart of the former Soviet Union and the world’s only third-world superpower. This year, using a purchasing power parity basis, Russian GDP stands at $1.287 trillion, or 11th largest in the world. Their real growth rate in 2003 was 7.3%. The growth rate has averaged 6.5% per year over the past five years, after the 1998 crisis.

Since 2000, demand by consumers and investors have been consistently strong. Real fixed capital investments have gained more than 10% per year, on average, over the last four years. Real personal and family incomes have seen increases that average more than 12%.
Financially, Russia has also moved a long way toward putting its house in order. Its foreign debt has declined from 90% of GDP during the 1998 crisis to around 28%. (The “foreign debt as percent of GDP” figure for the U.S. is 23%, and climbing fast). (data source)

Much of this boomlet is due to increased oil prices, of course. Recently oil has been trading at more than $40/barrel, with the end of July seeing prices of nearly $45. Russia has significant exports, making it the world’s second largest exporter of crude (after the Saudis). These oil export earnings have meant that Russia has increased its foreign reserves from only $12 billion to some $80 billion. Given how soft the ruble has been (often, it has been a non-traded currency), these foreign reserves go a long way toward establishing Russia as a legitimate global economy.

So….what is the problem? There are three problems: oil prices, credible commitments to guarantee private investments, and the survival of democratic institutions.

Oil prices: Petroleum giant Yukos, and its embattled former CEO Mikhail Khodorkovsky, both face legal problems for tax evasion and fraud. Yukos pumps about a fifth of Russian oil exports, or 1.7 million barrels per day. This is a short-term problem, because it drives up oil prices in the near term, but few believe the effect will last more than a month or two. Higher oil prices are more of a problem for the U.S. than for Russia, of course, since increased prices and the extremely low short-run elasticity of demand for petroleum products mean Russia will lose little in terms of revenue, and may well gain in terms of profits.

Credible Commitments: The “crime” of Khodorkovsky, and Yukos, was non-payment of taxes. But no Russian companies, or citizens, pay taxes. The rates are confiscatory, and the authorities openly wink when they make tax collection demands. What Khodorkovsky really did was openly support, both personally and financially, the political opposition to Putin’s increasingly repressive government.

Don’t get me wrong: Khodorkovsky has engaged in practices that most of us would call corrupt, and his initial seizing of oil assets marked him as one of Russia’s notorious “Oligarchs.” The Oligarchs are a type of Robber Baron but without the warm and fuzzy side displayed by John D. Rockefeller in establishing Standard Oil.

The best way to describe why this is a problem is to quote from David Storobin’s July 21, 2004 post on The Eurasian Politician, which is the best and most succinct summary I’ve seen:

In 2000, Vladimir Putin came to power and offered a sort of amnesty program where the Oligarchs were forgiven their "sins" if they ended their corrupt practices and stopped meddling in political affairs. The compromise made a lot of sense to those familiar with Russia. Communism corrupted the nation beyond what is imaginable in the West. One could not do anything – buy a refrigerator, take a test in school, go on vacation – without paying a bribe. Naturally, to be able to pay bribes, one had to have income other than your regular monthly pay – which was not even enough to buy food, much less pay for housing, clothes and other expenses. It was simply impossible to prosecute the whole nation and it was clearly better to break with the past, so long as people did not commit unlawful acts in the future.

Yet, almost immediately, Putin went after the Oligarchs who threatened him politically. His enforcement of law was very selective, punishing only those he was afraid of.
First came Vladimir Gusinsky, the owner of a major media conglomerate Media-Most, who opposed Putin during the 2000 elections. Putin simply took over Media-Most and Gusinsky was forced to flee Russia.


Next came Boris Berezovsky, who actually helped Putin in 2000, but was seen as a king-maker, and thus, too powerful for the Russian President. He was followed by a number of less high-profile businessmen, including Platon Lebedev – Khodorkovsky's right-hand man. Finally, Khodorkovsky was arrested and his company assets frozen.
Meanwhile, the Russian government took over all major TV channels and almost all independent media of any significance, leaving only a few minor stations and newspapers, many of which support Putin anyway.

In an attempt to gain even more power, the President went after the weak opposition parties and by 2003, Yabloko, SPS and the Fatherland found themselves outside the Duma. Fatherland was a moderate party, while Yabloko and SPS were American-style parties that supported capitalism and human rights. Part of Putin's strategy in sidelining these parties was to intimidate and destroy anyone – including Khodorkovsky – who helps the opposition.

As Russia's wealthiest man with a fortune of $8 billion, Khodorkovsky had the means to politically harm Putin today and replace him in the future, even hinting his (Khodorkovsky's) desire to be elected President some day. That could not be tolerated by the current Russian President – a career KGB officer. What Vladimir Putin wanted was to become such a strong President that nobody would be able to stand up to him and he'll be able to push through the program that he thinks will save Russia.

From the start, Putin understood that private ownership of major business and the profits that result from it, major media and opposition can all limit his power. By offering a "compromise" in 2000, he lulled businessmen into hibernation, while "picking them off" one by one, and taking over their money and media ownerships.

By 2003, Russia had become a "managed democracy" where elections were held, but the media was controlled by the government, opposition was threatened, and the only people who could challenge the President – the wealthy elites – were on the run outside the country or in jails.

When Khodorkovsky was arrested, he was a model of a businessman. More than anyone else, he had taken the "Putin Compromise" to heart and ended his corrupt practices. Yukos subscribed to American-style accounting – the most intense and accurate way to calculate corporate activities; he kept only one set of accounting records; his employees were well paid and he gave a tremendous amount of money to charity.

I’ll come back to Storobin in a minute, but the point is now clearly made: The only way to attract foreign investment is to make a credible commitment not to expropriate assets. This points up the classic time consistency problem in economics: “Time consistency is a phenomenon that occurs when it is not in the best interest of a player to carry out a threat or promise that was initially designed to influence the other player’s actions.” (Economics, Stiglitz-Walsh) In our case here, the government promises investors it won’t steal their assets, or extort payments that reduce the value of those assets.

At the time the promises are made, the government means these promises. It really wants to attract outside investment, and everyone is better off if the deal can be struck: I promise not to steal your stuff, and you buy a lot of stuff and set it up in my country in a way that it can’t be cheaply or easily removed.

But once the “stuff” (factories, complex systems of wiring and pipes, large machines) is in place, the temptation to steal becomes overwhelming. Worse, in a democracy with no history of rule of property law, a President cannot bind future leaders, and his promise is worthless.

The result can be a complete market failure: investments that would be very profitable, and would make money for all concerned, don’t happen because the promises of the government are not credible.

Russia has invested nearly 15 years in trying to make the “we won’t steal your stuff” promise credible. Now, one could argue that all the stuff was stolen to begin with, by the Oligarchs. But it is important that the government be seen not to be the most dangerous source of theft, because the government has the tanks and the troops. Private investors might be willing to take their chances on fighting back private theft, if the government backs them up. But if Putin’s government is the one taking assets, foreign investment will dry up completely.

Survival of Democratic Institutions: David Storobin continues, in his July 21, 2004 post.

[Khodorkovsky’s] arrest signaled to the world that Russia is turning autocratic. After all, why didn't Putin go after less reformed businessmen? Why Khodorkovsky, the most honest major businessman in Russia today? And why was it done right before the elections?

Immediately $8 billion were taken out of Russia in the last quarter of 2003, compared to $100 million in the first quarter. This also reduced the power of the business class in favor of Putin, who swept the elections in March 2004 with a spectacular victory over sub-par opposition.

It would be wrong to say that Russia is no longer a democracy. It does hold elections with opposition. But what Putin's Russia lacks is equality under the law, total and complete individual and property rights, as well as free and independent media and opposition that is not harassed and assaulted by the government.

In the wake of the 2004 elections and Khodorkovsky's arrest, the Putin Administration is omnipotent. There is nobody to stand up to Putin -- every other businessman and opposition member is threatened to wind up in the same jail as Khodorkovsky. If Russia's wealthiest and most reformed businessman may be imprisoned and have his property confiscated (which will almost definitely happen in the near future), why not anyone else? Why not everyone else?

This is the most interesting problem, because it is uniquely Russian. It has become common to cluck and shake one’s head at the problem Russia has had creating democratic institutions. The failure is sometimes explained as “cultural”: The Russians simply don’t want democracy, because that is not their nature. They choose the strong man over freedom, order and security over the divisions democracies create.



In light of this claim, one might begin to suspect that “Russia is becoming an autocracy” might actually be what the Russian people want. But an interesting, and (I think) very important article in the New Republic (May 31, “Velvet Glove: Why Russians Want Democracy”) calls this claim very much into question. Since the piece is open only to subscribers, let me paraphrase some parts.

First, the democratic impulse is extremely strong in Russia, particularly among urban youth and elites of all ages. They enjoy, and have come to expect, democracy, and they are angry that Putin’s government is choking off democratic institutions.

Second, poll results indicate that Russians are far more concerned about human rights, financial security, and peace then the anti-democratic shibboleths, order and stability. These were unstructured choices, mind you: “Here are 24 things you might care about; rank them.”
Gessen issues a scathing indictment of the economic authorities, from the U.S. and other nations, who arrogantly and stupidly miscalculated the effects of economic reforms on fledgling political institutions. Derogatory names, such as dermokratiya (crapocracy would be one way to translate this) for the system of government, and demshiza (demoschizoids) for those who advocated democracy, permeated the Putin campaign. In short, according to Gessen, the West was complicit in creating a set of circumstances where Putin’s cronies ran not just against Yeltsin, but against the very institutions of democracy that Yeltsin had tried crudely to put in place.

So, those who think Russians don’t want democracy confuse cause and effect. To the extent that Putin was able to associate the economic disasters and disintermediation of the late 1990’s with “dermokratiya”, he was able to tar those particular advocates of democracy as ridiculous failures. But democracy itself is still the core value (again, according to poll results) of nearly ¾ of all Russian citizens. Putin’s actions are not subtle, but they are not what Russian’s want.
Gessen finishes with a call to arms. “If foreign observers respond to the ongoing destruction of Russia’s democratic institutions by reassuring themselves that Russians didn’t want democracy in the first place, they will be betraying the Russian people’s valiant, if unsuccessful, years-long struggle finally to live in a democracy.”