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  • What Went Wrong in Russia?Creating Perverse Incentives
  • James R. Millar (bio)

The collapse of Russia’s financial system on 17 August 1998 marked the end of the second phase of market reform, a phase that began in 1995 under the direct tutelage of the International Monetary Fund (IMF). Andrei Illarionov describes the death throes of that phase very well. As with the first phase, the “shock therapy” that was initiated in 1992 by Yegor Gaidar, this second attempt to transform Russia from a planned to a market economy has ended in failure. Both shock therapy and the Washington Consensus have failed in Russia, and as Illarionov points out, Russia is back to square one, having “lost almost 10 years.” In some ways, the prospects for reform are less promising now than was the case earlier because of the consequences of continuously falling real income for the bulk of the population, the concentration of wealth in a few hands (the “oligarchs”), the failure of new private ownership of productive capacity to rationalize and restore production, the wide-spread denigration of the very concept of market reform, and the alienation of external sources of finance and investment. Meanwhile, Russia is ruled by an interim government composed mainly of Gorbachev-era ministers that reports to an ailing, unpopular, and unpredictable president.

The proximate cause of the August crisis was a continuing, major fiscal imbalance. Despite repeated promises to the IMF, Yeltsin’s successive governments failed to reduce the sizeable budget deficit. Financing the deficit eventually ran the government into the ground. Illarionov points out that the burden of the government on the economy was very high and was maintained at that level because the policies of the Russian federal government and of the Russian Central Bank “were neither liberal, nor strictly speaking reformist. They were deeply populist, [End Page 87] paternalistic, government-driven, and even socialist.” Moreover, during the crucial months of summer 1998, according to Illarionov, the aim of government policy was to save the largest Russian banks (and thus the oligarchs) from bankruptcy at the expense of the Russian state. There was also apparently a game of “chicken” between the federal government and the Central Bank over which would come first, devaluation or default. Lamentably, as Illarionov illustrates, the default on foreign and domestic debt continued a pattern of treating government debt instruments as a form of taxation.

Interestingly, Illarionov views the financial collapse of 17 August 1998 as “the collapse of yet another attempt to extend a socialist model of economic policy in Russia.” That is, if I correctly understand his position, the failure to contain and manage the federal government’s budget deficit was caused by the desire to redistribute financial resources to accomplish social goals that were previously attained under Soviet governments by means of direct allocation under the plan. Although there may be a certain truth in this interpretation, I believe that it misses the fundamental causes of the failure of market reform in Russia. These fundamental causes lie in the ideologically driven transformation strategies that were applied without consideration or even understanding of the limitations of local institutional structures, and were pursued from above in the teeth of horrendous economic consequences and great distributional inequities. The attempt to transform Russia into a market economy has been characterized by incentives that have made a mockery of Adam Smith’s conception of the harmony between the individual pursuit of income and the public good. Instead, in Russia each individual transactor pursuing his own advantage has contributed to the destruction of the wealth of the nation. The critical failure has been the delinking of pecuniary gain from contribution to real output. As Wesley Mitchell has put it, making money in a market economy should require contributing a good or service to the economy at large. In Russia since 1992, however, a small minority has received large monetary rewards while contributing essentially nothing to the real economy, which has declined continuously.

The first phase of market reform in Russia began simultaneously with the breakup of the Soviet Union at the end of 1991. Shock therapy, as applied in Russia, was as much a political as an economic strategy. Yeltsin...