Russia's Virtual Economy

Clifford G. Gaddy and Barry W. Ickes

From Foreign Affairs, September/October 1998

Article preview: first 500 of 5,159 words total.

Summary:  The assumption behind the International Monetary Fund's recent bailout of Russia is that the country is gradually reforming its economy according to market principles. But Russia's economy is much smaller than official figures suggest. Workers, the government, and industry all accept the myth that the manufacturing sector produces value, when in fact what it makes is worth less than the labor and resources it consumes. The result is a mountain of wage and pension arrears and government debt that will continue to provoke crises. The day of reckoning will be much worse if the West does not pull the plug soon.

Clifford G. Gaddy is a Fellow in Foreign Policy Studies at the Brookings Institution. Barry W. Ickes is Associate Professor of Economics at Pennsylvania State University.

BEYOND THE BAILOUT

The immediate causes of Russia's current financial crisis are clear -- a large budget deficit and an inability to service the debt, especially short-term dollar liabilities. Equally straightforward steps to solve these problems have been widely proposed. Moscow is being asked to reduce its budget deficit by collecting more taxes and cutting spending. International financial organizations and Western countries in July pledged an emergency loan package of $17 billion to stabilize the immediate financial crisis and restructure the short-term debt. These measures, it is argued, will allow the government to get back to the business of market reform.

But such measures cannot remedy Russia's economic problems. They are premised on a fundamental, but nearly ubiquitous, misunderstanding of the Russian economy, which goes something like this: Russia showed early success in market reform, but progress has been slowed by widespread corruption, crime, and incompetence. The explosion of barter arrangements and nonpayment of wages and taxes is due to faulty management of enterprises. Poor tax collection has weakened the state. Overcoming these obstacles is a formidable challenge, but if they can be surmounted, movement toward the market can continue.

In fact, most of the Russian economy has not been making progress toward the market or even marking time. It is actively moving in the other direction. Over the past six years, Russian companies, especially in the manufacturing sector, have indeed changed the way they operate, but to protect themselves against the market rather than join it. What has emerged in Russia is a new kind of economic system with its own rules and its own criteria for success and failure.

The new system can be called Russia's virtual economy because it is based on an illusion about almost every important parameter: prices, sales, wages, taxes, and budgets. At its heart is the pretense that the economy is much larger than it really is. This pretense allows for a larger government and larger expenditures than Russia can afford. It is the real cause behind the web of wage, supply, and tax arrears from which Russia cannot seem to extricate itself.

The virtual economy is robust, deep-rooted, and broadly popular. For those reasons, it has defined a new reform agenda basically aimed at preserving current arrangements. The virtual economy presents the West with difficult choices regarding continued support of Russia's economic transition. The principal motivation for providing bailout funds is a belief not only that more money is required to preserve social and political stability but that strings can be attached to induce more reform. The opposite, however, is true: a bailout will prop up the virtual economy, which is fundamentally not market-based and whose inefficiency will ensure continued economic decline and further crises. A bailout will merely postpone the day of reckoning. When that day comes, the economic consequences and political backlash will be even worse.

REALITY AND PRETENSE

A close reading of the statistics reveals the reality of the Russian economy. After 8 years of decline, according to ...

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