Jenny Yang

David Hauge

Transition and Government

“Russian reformers, placing too much faith

in the free market, gave too little attention to government’s role”

Quote

December 25th, 1991: Gorbachev resigns as USSR president

December 31st, 1991: Soviet Union officially dissolved

Post-Soviet Russia Boris Yeltsin becomes president - elected June

1991 Soviet Administrative Command system needs

restructuring Within days of dissolution, Yeltsin employs

program known as “Shock Therapy”

Collapse of the Soviet Union

“Shock Therapy”(1) Liberalization – provides freedom(2) Privatization – provides incentives(3) Stabilization - provides the

environment so that private enterprises can thrive

Transition to Capitalism

Soviet Command System

Government determined prices

Firms produce what government authorities decide

Relied on government oversight to curb malfeasance and incompetence

Market determined prices Firms produce to maximize

profit Relies on market

competition to curb malfeasance and incompetence

Comparison Free Market System

Competitive-equilibrium modelConsumers selfishly maximize utilityFirms maximize profitPrices adjust to ensure supply-demand

equilibriumThree essential elements

Market-determined pricesProfit maximizationCompetitive markets

Market Economy

Belief:Resources allocate efficiently and create

prosperityThree elements would emerge

spontaneously once the command system was terminated

If there is a problem, it is because the government is intruding

Primary challenge: Keep government out of the economy

Market Economy

Results:Industry stunnedSteep drop in living standardsTransfer of wealthCorruptionCollapse of Investment

Realization:Government necessary in multiple roles

Market Economy

In the Soviet era, prices poorly reflected economic cost False assumption: Decontrolling prices would

allow Russian economy to leap forwardPrice controls removed on January 2nd, 1992

Inventory reappeared on store shelves Price increases were enormous Industry hobbled government revenue fell

Importance of government Price regulation merits a restrain on inflation,

slows change in the price structure, and is imperative for monopolies

Prices

In the 1960’s, Soviets increase enterprise autonomy Began using profit as a measure of performance But, other two essential elements absent

During Shock Therapy, there was a struggle for control over previously state-owned enterprises and their assets Costly paternalistic practices Autonomous profit-maximizing firms, even in

competitive markets, don’t automatically serve the public interest

Importance of government Suitable institutions necessary to channel profit

maximization and serve the public interest

Profit

In Soviet economy, there were no wholesalers to provide backup inventory, products supplied by monopolies

Hope that with Shock Therapy, competitive markets would emerge overnight Instead, organize crime and anticompetitive

structures evolved, controlled by oligarchsImportance of government

Encourage growth of wholesalers and middlemen and protect them from criminal infiltration

Dismantle monopolies and disallow mergers that would reduce competition

Minimize licensing requirements and open economy to capital inflows

Competition

Transition is about change, equilibrium is inherently static

Government initiatives needed to address:ChangeCriminalizationDe facto colonizationInequality

Institutional framework needs to be sound

Looking Deeper

Absence leads to uncooperative behavior, criminalization and social disorder

Only government can: Define property rights Provide genuine security for private property Ensure enforcement of contracts without

violenceFormation is a gradual processRegard for common good is vital

Institutional Framework

Escalating corruption and economic inequalityDemand decreased

InflationSupply channels were disruptedRuble appreciated dramatically

Russian products less competitiveFear of collapse in the exchange rateFurther erosion of demand

Problems

Defined: Government intervention to foster development of particular sectors of the economy

Conflicts liberalization-privatization-stabilization requirements of transition

But, virtually all successful modern economies have relied upon government intervention to support industrialization (U.S., Germany, Japan, China, etc.)

Provides assistance in the short run so that industry can be internationally competitive in the long run

Simple empirical model suggested: Four Spheres Directs attention to actual economic conditions

Industrial Policy

Largest of the four: accounts for 40% of employment

Demise under competitive-equilibrium modelMarket discipline, even if improved, won’t

revitalizeGovernment intervention:

Don’t revive firms lacking potential Facilitate movement of labor and capital to

lawful, dynamic businesses Intelligent industrial policy also needed

Sphere One: Industry and Agriculture

Essential issue: who benefits from nation’s wealth?

Under CE model, private ownership is superior Government doesn’t capture gains

Oil production fell in 1990’s as investment declined Foreign companies offered technology and

finance Russian capitalists reluctant, didn’t want to

lose controlGazpromGovernment monitoring and control is

required to tax fully the economic rents from natural resources

Sphere Two: Natural Resources

33% of employmentImportance of government in formative

stages of transitionDependence on low-cost transportation

and communicationBanksOther public services:

Health careEducationLaw, public safety and environmental

protection

Sphere Three: Public Services

Most relevant to CE model, appropriate for government to be more limited

Obstruction by control over housing Do need to curb crime

Decrease in formation of new businesses, attributed to mafia intervention Extortion Intimidation of competitors Bribery

Sphere Four: Small Business

Limiting government is consequential for growth of sphere four However, deliberate government action required in other three

spheres Since they are intertwined, improved conditions in any one

inevitably benefit the others Sphere two delivers financial resources to sphere three In turn, providing lawful economic environment and functional market

institutions essential for sphere one and the rest of the economy

“A government program responsive to all spheres would build market institutions, maintain aggregate demand for Russian goods and provide judicious support for economic development.”

Summary

Clifford Gaddy and Barry Ickes - 1998“An economy is emerging where prices are

charged which no one pays in cash; where no one pays anything on time; where huge mutual debts are created that also can’t be paid off in reasonable periods of time; where wages are declared and not paid; and so on. . . This creates illusory or ‘virtual’ earnings, which in turn lead to unpaid, or ‘virtual’ fiscal obligations, with business conducted at nonmarket, or ‘virtual’ prices.”

Table

The Virtual Economy

Basically, this economy has arisen for two reasons: Most of the Russian economy takes away value Most participants pretend that it doesn’t

The Virtual Economy