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Facing New Challenges

April 15 - 21, 2002

Recently, Andrew Wilson, CIPE Senior Program Officer for Central Europe and Eurasia, had the opportunity to interview Anders Åslund, a renowned expert on Russia and the former Soviet republics and a senior associate at the Carnegie Endowment for International Peace. Mr. Åslund is the author of a new book on this subject: Building Capitalism: The Transformation of the Former Soviet Bloc (Cambridge: Cambridge University Press, 2001).

CIPE: The relationship between democracy and markets is a theme that has been present in quite a few of your writings. In your opinion, to what extent does democracy help the development of a market economy and, on the other side, does the development of markets help to stimulate democratic development?

MR. ÅSLUND: Markets and private ownership generally exist together with democracy. But you can point out some exceptions, largely East Asia, which has not been very repressive, and Chile under Pinochet. In the post-communist region you have specific conditions that make it all the more important to have democracy in order to get markets. The first element is that the state was so dominant in these countries that in order to stop the state from intervening you have to have democratic control over the state.

Establishing a market economy required first privatizing the state enterprises, but political opportunists and former communist managers took full advantage, selling themselves these properties very cheaply. Democracy is a way of stopping the privileged nomenclature from taking everything. There is an extremely close correlation between market economic reform, privatization, and democracy. Central Europe and the Baltic states have done all of it. They are fully democratic, they are about three-quarters privatized, and they have recently gone to market economics. At the other end you have countries that are totally state controlled, totally state owned, and fully fledged dictatorships, in particular Belarus, Turkmenistan, and Uzbekistan.

CIPE: You have written about countries implementing only partial economic reforms and compared these to countries that implement full reforms and no reforms in Eastern and Central Europe. What is the effect of partial reforms?

MR. ÅSLUND: In Central Europe and the Baltic States where they have instituted complete reforms they are doing very well. The situation is more interesting in countries that have undertaken only partial reforms like Russia and the Ukraine, compared to those that have undertaken no reforms, like Belarus, Turkmenistan, and Uzbekistan.

The argument against partial reform is that it is worse than no reform because if you fail then you're worse off than if you hadn't even tried. I disagree. What we have seen over the last three years, it is that these partial reforms in Russia, Ukraine, and Kazakhstan in particular, have taken hold. Russia has had an average growth rate of six per cent during the last three years. And while these countries did become rent-seeking societies, it was short lived.

CIPE: Could you define "rent-seeking" and rent-seeking behaviour?

MR. ÅSLUND: Rent-seeking is earning an excess profit over market, the competitive market equilibrium. Rent-seeking behaviour is an attempt to get a privileged position on the market through state subsidies or regulations.

Essentially, the Russian financial crash of '98 demolished the rent-seeking society as it had been established, and what we are now seeing is splendid growth this year. Russia will have probably six per cent of growth. The Ukraine and Kazakhstan will probably both have ten per cent growth. That means that you have new groups in society becoming empowered and they will not allow the old rent-seeking system to come back there. The last three years have shown us that it's better to undertake some reform than not undertake any reforms at all, and that any reform is really an investment in the future.

It's true, however, that you can end up in a reform trap. Politically, if you don't do enough reform, the people will be unhappy because the economic performance will be poor. This results in the communists getting a lot of support, and when the communists are strong, reforms can't be implemented because they don't want to move towards a market economy.

Economically you have the problem of privatization. Investors will first seek to buy up state properties cheaply and liquidate them. They won't care about investing in the enterprises and restructuring. There will be limited growth and limited investment in private companies until something like 60 per cent of state owned property is privatized.

Another problem is in terms of deregulation. When you have rent-seeking mechanism, like state subsidies or other regulations from which some rent-seekers make a huge amount of their rent (profit), those people will buy political power. You'll get a conservation of the rent-seeking mechanism, and this is quite resistant. In order to break it up, you really need the kind of shock that comes when a country's deficit has been too big for too long, usually, the amount of the debt burden becomes excessive, as with the case of Bulgaria in '96 and Russia in '98. It is this type of financial crisis that brings change.

What happened in Russia in '98 is quite typical. There were three groups that were really badly hurt strategically. First, the oligarchs — made up of former communist managers of state owned enterprises and other party leaders who used their positions to profit from privatization — were weakened when the state took back its prerogative. The oligarchy no longer called themselves oligarchs instead they called themselves businessmen. They could no longer afford to buy political power because they lost a lot of money to the crash.

The other group that was hurt was the regional governors, which in Russia in '98 were really the epitome of state corruption. The worst corruption was at a regional level and the biggest enterprise subsidies were at that level. After the financial crash, these governors were weakened politically so that the federal government could take control of tax revenues, manage the state debt and balance the budget.

The third group that was weakened, most surprisingly, was the communists, because what the financial crash showed was that halfway reforms don't work. We tend to talk about it as crony capitalism with the emphasis on capitalism, but it was more a perception that this was halfway communism, and after all, everybody realized that the old system didn't work. So then you have to go to real capitalism. Before the parliamentary elections in December '99, the Russian communist party actually changed its economic programme so that it became in favour of reform.

This did not happen right away and the immediate reaction everywhere was that the Communist Party would benefit from this, and indeed, several top communists joined the government. But one year later, the afterthought was that it's really halfway reforms that don't work, and nobody really supported the resurrection of the communist planned economy.

The result is that Russia has now an enormously clean market economic system, much more, I think, than you see virtually anywhere in the West, because people are so much more aware of the principles of the market economy. There's a much more acute awareness of what a market economy is and why it's necessary to have it than virtually anywhere else.

CIPE: In a country as large as Russia, can the central government alone move reform forward, and in the case of the regions, how do you see the reform process moving into the regions?

MR. ÅSLUND: I think that the first point is to say is that the federation had become far too weak in relation to the regional governments. If you take it in the terms of the economy, the regions until '98 had about 15 per cent of GDP and the federation had nine per cent of GDP. In the U.S., the federation has about 20 per cent of GDP and the States a bit more than ten per cent. So two-to-one is the U.S. ratio, and the Russian ratio then was one-to-two. The Russian federal revenues are now about 17 per cent and the regional revenues something like eight to nine per cent of GDP, and I think that these are much more proper proportions. Economically, the proportions have been properly established, and the federal government is far more transparent than the regional governments. That's the economic side.

Politically, what happened in the summer of '98 was that the regional governors prevented the balancing of the federal budget by not allowing more money to go to the federation, so they were directly responsible for the financial crash. I think redoing the tax system, if they had accepted that could have still in July '98 possibly averted the crash.

Another political part is that the regions are far less than accountable or transparent than the federation. Moscow has 20 to 25 daily newspapers, while in the regions you only have one dominant newspaper that is controlled by the government. So when talking to democracy activists in Russia, you find that in Moscow, they are concerned about Putin's power, but in the regions, the democracy activists look to Putin's strength as a possibility of getting their totally undemocratic regional government somewhat under control.

So there's actually a democratic pressure in favour of stronger federal powers because the federation is more democratic than the regions, and after this has worked for some time, I think that the regions will come back politically because they have lost legitimacy now by being undemocratic and being more corrupt than the federal government.

Therefore, I'm not too worried about Putin's policy on federal-regional relations, but I basically think that to get the regional governors out of federation policy you want to have some kind of senate where you have regional interests represented but not by the same governors. The current structure of the federation council is approximately like this and I presume that Putin has taken the German federation council sort of as his model. I would argue that Putin has greatly improved federal-regional relations, improved transparency, and improved democracy in this regard.

The concern about Putin is that this is a top-down reform we are seeing, and it would be nicer if it were a more grassroots-oriented reform. Ukraine is pursuing that kind of reform, simply because the elite consensus has broken down. The new consensus is about corruption and debt, and, therefore the top members of the elite can no longer collude on how to make money on the state. The result is that they are losing influence and power and the country benefits because new businesses can be created without any dependence on government subsidies.

In Ukraine, there are today seven million enterprises registered. In Russia, there are three million enterprises registered. So Ukraine has one registered enterprise on seven people. Russia has one on 50. Russia has become a very big enterprise-dominated economy, and reform oligarchs have now become the big, strong businessmen. This is quite similar to what you had in Sweden or Finland at the early stages of their economic development. I think it's much better if you have the small enterprise development like in Ukraine.

The critical economic decision that helps small enterprise development is to introduce lump-sum tax that is fixed for a substantial period for small business, so small businesses have only one relationship with government, paying the lump sum tax, one a year, and not being subject to inspections or certification or licensing.

CIPE: What sort of reforms did Ukraine undertake?

MR. ÅSLUND: Ukraine is one of the most interesting transitions and the reason why anything happened was that Ukraine was on the verge of collapse. It was really facing an external shock, and while the foreign debt was not very big, Ukraine had no credit so it couldn't get any financing. Such a hopeless situation requires a man with great credibility both at home and abroad, which happened to be the very reformist president of the national bank, Victor Yushchenko. After being appointed Prime Minister, he used this brief time when the country was really hanging by a thread to undertake a few major reforms.

His first decision was to abolish 250 government positions and regulations that gave privileges to many businessmen. Then he appointed one of the oligarchs Yulia Tymoshenko as Deputy Prime Minister for Energy and she was happy to go after the other oligarchs. You need a person who understands how the money is being made. My assessment is that she took four billion dollars in current annual revenues away from the oligarchs with her policies, cleaning up the energy sector, particularly in gas and electricity, and that was about 13 per cent of GDP.

Profound land reform placed half of the land in real private hands and the harvest this year is up by 50 per cent. Also a lump sum tax for small businesses, which had been there already, really took off in the last two years so that there is huge growth in agriculture and in industry of 17 per cent so far this year.

CIPE: Do you think this economic success will translate into greater political reform?

MR. ÅSLUND: Yes, and you can see this immediately. The oligarchs were buying up all the newspaper and broadcast advertising preceded the last presidential elections in October-November '99, and they could do so because they had so much money from the state. Now, they don't have the money and they can't run commercials. One of the television channels is now owned by one of the more progressive Russian groups and they are running probably the best television channel in Ukraine. Since the oligarchs are not likely to dominate the media as they did the last time around, the elections will be more competitive.

CIPE: Now that the oligarchs and the communists seem so weakened in the region what is the next big threat to reform?

MR. ÅSLUND: With the oligarchs under control, the problem is the police, the security services, and the tax collectors. These are now the three most criminal organizations. The big issue today is to get judicial reform to clean up law enforcement. Russia has adopted federal laws on judicial reform and this is a fundamental change.

CIPE: In your articles you suggest that foreign investment should not be a big priority, and that most investment is domestic.

MR. ÅSLUND: The West heavily overemphasizes foreign investment because it's a Western interest. Azerbaijan has received the most foreign investment at about 20 to 25 per cent of GDP in the last year. There's nothing positive to be said about corporate governance in Azerbaijan, property rights, legal rights, liberalization. Out of 21 countries, and there has been a slight improvement in recent years, but it's only small, and, of course, Azerbaijan is one of the true dictatorships in the region.

In Central Europe, the countries with the least foreign investment, relatively, are Poland, the Czech Republic and Hungary. Hungary is a success story, but it has been lagging behind Poland in growth rates. The Czech Republic got a lot of foreign direct investment in relation to the size of its economy and it has been pretty stagnant in the second half of the 1990s. In Russia, foreign direct investment is two percent of GDP while total investment is about 20 per cent of the GDP. So it's not so important in terms of the total. This is not to argue against foreign direct investment, but it should not be seen as a panacea.