This Bailout Will Set the Stage for the Next Crisis

The Los Angeles Times, July 17, 1998

By Clifford G. Gaddy, Fellow, Foreign Policy Studies
The Brookings Institution, Washington, D.C.
and Barry Ickes, Pennsylvania State University
Once again, Russia has managed to get a multibillion dollar bailout from the West. Once again, the West has made Russia promise that it will get serious about economic reform. Led by the International Monetary Fund, the Western lenders have posed a series of demands, including reducing the government's budget deficit, enacting tax reform and combating the massive theft and corruption that plague the system.

On previous occasions, handing over the money was considered risky because Russia would just take it and then not follow through on reform. Today, ironically, the danger is that Russia might actually do some of the things we ask. The reason for concern is that in the current economic situation in Russia, standard economic reform measures are likely to have effects directly opposite those intended. The outcome could be that today's bailout would become merely the first installment of a continuous stream of infusions needed to keep the Russian economy afloat.

To understand why a bailout this time is likely to be not merely ineffectual but even harmful, it is crucial to recognize that what has emerged from the past six years of reform in Russia is not a market economy. Rather, it is a distinct economic system, neither purely communist nor capitalist, which we call the "virtual economy." "Virtual" because it is based on illusion or pretense about almost every important parameter of the economy--prices, sales, wages, taxes and budgets.

The most essential element of pretense in the virtual economy relates to the many enterprises inherited from the Soviet era that still produce goods but destroy value. The truth about these woefully noncompetitive enterprises is systematically concealed through an elaborate system of artificial pricing based on barter and other forms of noncash payments. The enterprises can procure inputs, hire workers and produce lots of worthless output almost without the use of cash.

The reason they can operate like this is that value is being transferred to them from other sectors of the economy that actually do produce value. These are primarily the resources sector, led by the giant natural gas producer, Gazprom, and also households, which supply labor but are frequently not paid. But this means that the most productive parts of the economy are being eaten away, leaving a Russia that is poorer, not richer, for every day the virtual economy continues on its present scale.

Why would value producers participate in a system that taxes them to support a value-destroying manufacturing sector? One reason is that the virtual economy sanctions some "leakage" of value out of the system and into the pockets of the value-adders.

Consider Gazprom. It is Russia's largest earner of export revenue, its largest taxpayer and also its largest tax delinquent. Less than 8% of Gazprom's domestic gas deliveries are paid for in cash. The rest are paid for, if at all, in bartered goods or promissory notes. But in return for supplying the entire domestic economy with natural gas nearly free of charge, Gazprom is allowed to continue to export gas for dollars. Its support of the domestic economy is the price it must pay in order to remain an independent private company.

While this leakage of value to Gazprom's owners is sanctioned as a necessary cost of keeping the virtual economy in operation, there are other forms of leakage that have directly harmful effects to the system's ability to survive: theft, corruption and capital flight.

Viewed in the context of leakage, the relationship between fighting corruption and economic reform takes on greater complexity. Reducing corruption is typically considered a key element in accelerating economic reform. In Russia's virtual economy, the opposite may in fact be the case. If reducing corruption results in less leakage from the system, more value remains to support the continued operation of loss-making enterprises.

The same is true of another key element of reform in Russia: stopping tax evasion. Cracking down on tax evaders is another way of plugging the leaks. It makes the system more sustainable because it makes available more value that can be used to offset value destruction.

There is, of course, one more way to compensate for the virtual economy's destruction of value. That is an infusion of funds from the IMF. By injecting value into the system from the outside and by insisting on policies that reduce the harmful leakage of value out of the system, Western financial support unintentionally becomes complicit in the survival of the virtual economy. Rather than hastening true structural change, a bailout that is predicated on the standard prescriptions and that ignores the workings of the virtual economy will only set the stage for the next crisis.

© Copyright 1998 The Los Angeles Times


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