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Lessons of the Russian Crisis for Transition Economies
Yegor Gaidar
Soft budget constraints and weak administrative controls brought Russia to the brink
of hyperinflation. The lesson is to disinflate rapidly and to impose hard budget
constraints quickly.
What lessons does the Russian financial crisis hold for other economies in transition?
I could approach the topic by providing an avalanche of details about exchange rate,
interest rate, and budgetary policies, or, perhaps more interesting, details about errors
committed by the Russian government, the Russian central bank, and, yes, even the IMF. I
will not do so, however, but will instead focus on the problem of soft and hard budget
constraints.
Soft budget constraint
The concept of the soft budget constraintessentially a lack of financial
accountability by enterprise managerswas first elaborated by nonsocialist economists
for enterprises under the socialist system. The application of the term to enterprises in
transition economies and in postsocialist economies is, in my view, entirely appropriate.
Under the socialist system, the authority of the enterprise manager had nothing to do with
whether or not the enterprise was profitable. The soft budget constraint was normally the
result of a state budget process far removed from considerations of efficiency or profit.
Under market conditions, because profits are the very essence of a manager's authority,
the soft budget constraint is rare and always temporary. The market economy, as you well
know, is founded on very tough budgetary discipline. A manager whose indifference to
budgetary considerations allows an enterprise to fall into bankruptcy suffers a swift and
unpleasant fate.
Hard administrative constraint
On the other hand, under the socialist system, soft budget constraints coexisted with
hard administrative constraints. Since each enterprise was part of a comprehensive
hierarchy, the state exercised rigid control over the appointment of managers and made
sure that they fulfilled the tasks assigned to them, including the achievement of
wide-ranging social aims. When, however, the totalitarian socialist regimes began to
disintegrate, administrative control over the enterprise managers also fell apart. In some
stage of development in all postsocialist economies, this phenomenon led to a fatal
combination of soft budget controls and soft or nonexistent administrative controls.
To understand the attitude of managers in the socialist system, try to imagine an
economy in which an enterprise owner has no need to be concerned when the enterprise fails
to turn a profit. He knows that a weak bottom line will be compensated by various
budgetary understandings, such as subsidies, loans on easy terms, and the possibility of
allowing tax arrears to build up without untoward consequences. Imagine what this would
mean for the general efficiency of the market mechanism!
First, it would mean that the usual market instruments for redistributing resources
from poorly functioning, inefficient enterprises to better-functioning, efficient ones
would not work. The discipline of the market would be rendered ineffectual.
Second, because soft budget constraints are incompatible with an equitable and
efficient tax system, the enterprise's tax obligation would be determined in practice not
by tax law but by the terms of a contract negotiated between the enterprise and the state
authorities. Such negotiations invariably lead to corruption.
Worst of both worlds
As I just mentioned, practically all postcommunist countries have experienced problems
with this combination of soft budget constraints and soft administrative constraints. What
is the difference between "market socialist" economies before the start of
serious reform and in the postcommunist reality? Before the reforms, enterprise managers
were firmly under a system of totalitarian political control. They had to behave. They had
to show that they were loyal members of the party. It is also unfortunately true that many
managers skimmed off funds from the enterprises, enriching themselves and their families.
There were limits to such transgressions, however. The enterprise still had to meet the
requirements of the central plan and still had to provide for the welfare of its workers.
Failure to carry out fundamental managerial duties would be regarded as breaking the
manager's contract with the political establishment. This was simply not done and could
result in serious repercussions for the offending manager.
After the crash of communism, the totalitarian regime, with all its social and
administrative restraints, ceased to exist. Then, the combination of easy budget
constraints and easy administrative constraints produced most undesirable consequences for
the enterprises, for society, and for the economy as a whole. These developments were
entirely to be expected, given the social environment that emerged after the breakup of
the totalitarian regime. Why? First, because of a mind-set deeply ingrained over 70 years
of socialism. Far from being distinct entities, enterprises were regarded as part of the
state, a result of socialist industrialization. How could an enterprise be disciplined on
the trivial grounds that for a time it was unable to fulfill its tax obligations? It would
be absurd: the duty of the state was to provide for the enterprise, not the other way
around.
Second, because enterprise managers were part of the social infrastructure of the
totalitarian society, they were in no way different from other officials in the state
administration. They had gone to university together, they worked together, they
socialized with one another. They could also collude together. Unless there were
countervailing political and legal safeguardsand over the past decade there have
been fewthis combination of feeble budgetary controls, weak administrative controls,
and "old boy" cronyism engendered an inefficient, stagnant, and extremely
corrupt environment.
Remedies
What could change this situation? What forces could nudge the economy in the direction
of tighter restraints on the enterprises? The first prerequisite is to deal with the huge
budget imbalances and monetary overhang that remain as the macroeconomic legacy of the
socialist era. Aspirations on the part of the political elite to conform to Western norms
of macroeconomic stabilization require a slowdown in the rate of money creation, a
reduction in the budget deficit, and the elimination of soft budget constraints (including
a very hard stand against tax arrears). In Central European countries, such as Hungary and
Poland, that found themselves in a similar situation, and where these aspirations were
reinforced by the elite's commitment to join the European Union, governments acted
resolutely and quickly to impose serious, not to say harsh, financial discipline on
enterprises during the early stages of the transition. Their resolution was such that they
were able to eradicate the institutionalized culture of the soft budget constraint soon
after the transition began.
The Czech Republic provides an interesting example because, of all the socialist
countries, it found itself in the best financial condition at the moment of the crash of
the socialist economy, and its financial condition remained strong during the first years
of transition. Lulled into complacency as a result of its financial advantages, the
government failed to push seriously to harden budget constraints on enterprises. Despite
the Czech Republic's vaunted macroeconomic efficiency, the government delayed
restructuring, allowing the large state enterprises to continue to enjoy soft budget
constraints during the first three years of transition and implementing a bankruptcy law
only in 1993. The result of the delay was the loss of three precious years of development.
In the majority of cases, macroeconomic stabilization in the postsocialist countries is
inseparable from the microeconomy. Stabilization cannot go forward without budgetary
restraint at the enterprise level and a wholesale restructuring of inefficient operations.
In Russia, of course, macroeconomic policy during the first years of transition was
extremely weak, mainly because of a lack of political consensus and a division of
political power (as evidenced by rampant inflation during those years). Inadequate
budgetary and monetary constraints at the macroeconomic level combined with inadequate
budgetary constraints at the enterprise level.
Financing the budget
By the time monetary stabilization was attempted in Russia, inflation had eroded cash
balances and made the financing of budget deficits all but impossible. People were sick of
the prolonged inflation. The situation was quite different from what it had been at the
moment of the collapse of the socialist economy and demonstrated the folly of delaying
reform.
The erosion of monetary balances by inflation made the ratio of money to GDP much lower
than it would have been if disinflation had been attempted at an earlier stage. Moreover,
the freedom of enterprises to accumulate tax arrears also contributed to an erosion of
budgetary receipts. It was very difficult to challenge, let alone change, this firmly
established habit.
The government's ability to borrow in the domestic Russian market to finance the
deficit was severely limited by the lack of cash balances in the economy. Its budgetary
revenues were low, both absolutely and relative to revenues in those transition economies
that had begun the reform process earlier. And it seemed unable to legislate the drastic
cuts in expenditures necessary for monetary stabilization. Between 1995 and the first half
of 1998, the government struggled against easy budgetary restraints at the enterprise
level, huge budgetary imbalances at the macroeconomic level, and weak monetary policy. It
succeeded in tightening monetary policy, but it continued to struggle with its
microeconomic and macroeconomic budgetary problems.
During 199598, the problem of tax collection was not a problem of tax
administration in the usual sense. It was more a political struggle about what constituted
the essence of the emerging economic system, whether it was to be a system in which the
relationship between the state and the enterprises was to be regulated by law or whether
it would be business as usual, based on political influence and personal contacts. The
result of the struggle was what I would call a semi-equilibrium in which the budget
deficit was stabilized at around 6 or 7 percent of GDP, but there was not enough political
support to reduce this figure. Obviously, deficits of this magnitude are unsustainable in
the long run. They can continue perhaps for a year or two, but then the government must
either cut expenditures and restructure the interface between the state and the
enterprises or forget about monetary stabilization. The choice is clear.
Present dangers
Radical changes in the international financial climate since 1997 have posed a
considerable threat to the Russian economy with its weak financial policies. Unable to
reduce the budget deficit, the Russian government is finding it extremely difficult to
finance the gap entirely by borrowing from the IMF and the World Bank. Needless to say, it
is experiencing even more difficulty in finding commercial credits to finance the deficit.
Its ability to borrow commercially depends on swings in the mood of the international
financial markets. If these markets are optimistic and expansive, there is some breathing
space, but if the mood changes, the borrower is caught in a very serious trap. Foreign
investors are extremely wary of taking chances with an unpredictable exchange rate policy:
to attract capital, you must have a transparent and stable exchange rate. Capital inflows
will not occur if currency risks are not hedged.
Between the autumn of 1997 and August 1998, the Russian government faced a choice
between two possible strategies. The first was to demonstrate that it had the political
will to tighten the budget by reforming its relationship with large enterprises, such as
those in the oil and gas sectors, through the imposition of hard budget constraints. The
second was to give up, abandoning the attempt to promote anti-inflation policies.
Unfortunately, the attempt to tighten budgetary policy received insufficient political
support. The result was inevitable: the continuation of soft budget constraints, soft
budget policy, and soft monetary policy.
The first steps of the new government formed in September 1998 showed that it, too,
very much preferred the soft budget alternative. What were these first steps? First, it
negotiated tax agreements with the largest Russian taxpayers, thus institutionalizing the
practice of defining tax obligations not by law but by agreement. Second, it also
institutionalized a system of monetary offsets by allowing enterprises to pay taxes in
kind and by forgiving the debts of enterprises in the agricultural sector.
These are not isolated initiatives. They are part of a comprehensive policy (even if
the government does not recognize it) whose essence is to enable an elite to retain
control over valuable properties and to continue to manage enterprises, regardless of
their level of efficiency, while the state picks up the tab. This is what has been
happening in Russia during the past five months.
A word of advice
In conclusion, I would draw a number of lessons from the Russian experience:
- If the socialist economy no longer functions, the government should try to disinflate as
rapidly as possible. A delayed disinflation will be much more painful.
- If the government is confronted with delayed disinflation, it should cut budget deficits
radically.
- The illusion of being able to finance the deficit out of a short-term portfolio should
be abandoned.
- Consideration should be given to the vulnerability of the exchange rate regime to
changes in commodity prices.
- It should be understood that hardening the budget constraint is important not only for
raising budget revenues but also for allowing market mechanisms to work and thus for
increasing the efficiency of the economy.
Yegor Gaidar was Prime Minister of
Russia in 1992. He is currently Director of the Institute for the Economy in Transition
(Moscow). |
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