ber042] popov, v. -- russia- austerity and deficit reduction in historical and comparative...
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Cambridge Journal of Economics 2012, 36, 313–334doi:10.1093/cje/ber042
Russia: austerity and deficit reduction inhistorical and comparative perspective
Vladimir Popov*
This paper looks at Russian experience with austerity programmes since thebreakdown of the former Soviet Union in 1991. Downsizing of the state was oneof the major elements in a reform package designed to transform the centrallyplanned economy into a market one (together with deregulation, privatisation,macroeconomic stabilisation and the opening up of the closed economy). Thisdownsizing, however, proved to be the single most important reason for the collapseof state institutions, which in turn deepened the transformational recession,contributed to the dramatic rise of income inequalities, corruption and crime, andthe decline in life expectancy. The story of the successes and failures of transition isnot really the story of consistent shock therapy and inconsistent gradualism. Themajor plot of the postsocialist transformation ‘novel’ is the preservation of stronginstitutions in some countries (very different in other respects—from CentralEurope and Estonia to China, Uzbekistan and Belarus) and the collapse of theseinstitutions in other countries. At least 90% of this story is about government failure(the strength of state institutions) and not about market failure (liberalisation).
Key words: Downsizing the government, Institutional collapse, State capacity, RussiaJEL classifications: E02, H11, H50, P35
1. Introduction
The very notion of the state implies that public authorities hold monopolies on three
functions: (i) the legitimate use of violence; (ii) the provision of revenues by collecting
taxes; and (iii) the control of monetary emission. All three monopolies were undermined in
Russia during the 1990s to such an extent that the very existence of the state was put into
question. The government failure became pervasive and much more visible than the
market failure (Popov, 2004).
As compared with the period of the late 1980s, when the Soviet Union was still in place,
the volume of the provision of public goods in the 1990s shrank by at least half, the quality
of government services deteriorated dramatically and the effectiveness of the public
administration fell to its lowest level in decades. Pervasive government failure was apparent
Manuscript received 22 June 2011; final version received 15 November 2011.Address for correspondence: Vladimir Popov, DPAD, DESA, UN, 2 United Nations Plaza, DC 2-1444, New
York, NY 10017, USA; email: [email protected]
* The New Economic School, Russia.
� The Author 2012. Published by Oxford University Press on behalf of the Cambridge Political Economy Society.
All rights reserved.
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in virtually all areas, from collecting custom duties to taking care of homeless children, to
fighting crime.
The importance of an efficient state for reasonable economic performance and social
stability is normally well recognised by researchers and politicians, but it is often assumed
that state efficiency cannot change rapidly—either for the better or for the worse. However,
in some postcommunist economies the decline in state capacity was most extraordinary—
by 50% and more in an extremely short period of time (a matter of several years). The rapid
loss of state capacity in such a short period of time became a natural experiment that
revealed what can happen in a modern economy if the provision of basic public goods is
suddenly dramatically reduced.
The total amount of public goods provided by the government is equal to the multiple of
two indicators: (1) total government spending and (2) output of public goods per US $1 (1
yuan) of spending. The latter indicator—output of public goods per one unit of
spending—is the measure of state efficiency, whereas the former indicator—total
government spending—is a measure of state size. The idea of Russian liberal (pro-market)
reformers was that the smaller size of the state would be compensated by the higher
efficiency of government spending, but in reality the efficiency of the provision of public
goods declined hand in hand with the reduction of government spending. As a result, the
provision of public goods fell exactly when there was a need to provide more. When crime,
income inequality, poverty and corruption were on the rise, the state needed to spend
more, not less, to bring these unfavourable developments to a halt.
2. Decline of the state: collapse of state institutional capacity during
transition
The institutional capacity of the state is defined, for the purposes of the current paper, as the
ability of the government to enforce rules and regulations, including property and contract
rights, and law and order in general. When state institutional capacity weakens, companies
and households bear additional costs associated with the need to compensate for the lack of
provision of public goods that the state previously provided. A reduction in other government
spending, such as on social programmes, health care, infrastructure, etc., even if it does not
lead to a decline in the ability of the state to enforce rules and regulations, has other negative
implications, such as a rise in income inequalities, mortality, etc.
The efficiency of state and non-state institutions is not easily measurable. In most former
Soviet Union (FSU) and Balkan countries the collapse of state institutions was observable in
the dramatic increase in the share of the shadow economy; in the decline of government
revenues as a proportion of GDP; in the inability of the state to deliver basic public goods and
appropriate regulatory framework; in the accumulation of tax, trade, wage and bank arrears;
in the demonetisation, ‘dollarisation’ and ‘barterisation’ of the economy, as measured by high
and growing money velocity, and in the decline of bank financing as a proportion of GDP; in
the poor enforcement of property rights, bankruptcies, contracts, and law and order in
general; and in increased crime rates, etc. Most of the mentioned phenomena may be defined
quantitatively, with the remarkable result that China and Vietnam are closer in this respect to
East European (EE) countries than to the Commonwealth of Independent States (CIS).
However, the construction of the aggregate index of the efficiency of institutions is
problematic, because the rationale for choosing weights is not clear.
One possible general measure is the trust of businesses and individuals in various
institutions—here, FSU states rank much lower than EE countries in all available surveys.
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In a global survey of firms in 69 countries on the credibility of state institutions, the CIS
had the lowest credibility, below that of Sub-Saharan Africa (SSA) (World Bank, 1997, pp.
5, 35). Especially striking was the gap between EE and CIS countries: differences in the
credibility index between South and South-East Asia and EE were less pronounced than
differences between SSA and the CIS.
Another good proxy for measuring the institutional capacity of the state is the financial
strength of the government—the share of state revenues in GDP.1 Out of 30 transition
economies only several did not experience the sharp reduction of the share of government
revenues/spending in GDP during transformation—Estonia, Vietnam and Central
European countries (Czech Republic, Hungary, Poland, Slovak Republic, Slovenia)
(Figure 1); government expenditure/GDP ratios in Uzbekistan and Belarus fell less
dramatically than in other countries (Popov, 2000). It is easy to notice that these countries
are exactly the ones that exhibited the most favourable GDP dynamics: in Central Europe
the 2000 GDP surpassed the pre-recession level of 1989, whereas Uzbekistan, Belarus and
Estonia (in this order) came closer than other former Soviet republics to restoring the pre-
transition GDP level, and Vietnam did not experience any transformational recession at
all.
Though much has been said about ‘big government’ and too high taxes in former
socialist countries, by now it is rather obvious that the downsizing of the government that
occurred in most CIS states during transition went too far. This argument has nothing to
do with the long-term considerations of the optimal size of the government in transition
economies. It is true that in most of them government revenues and expenditure as a share
of GDP are still higher than in countries with comparable GDP per capita. But whatever
the long-term optimal level of government spending should be, the drastic reduction of
such spending (by 50% and more in real terms in the course of just several years (Figure 2))
cannot lead to anything else but institutional collapse. Simply put, if crime, income
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Fig. 1. Consolidated government revenues as a percentage of GDP.Sources: EBRD Transition Report, various years; De Melo et al., 1996.
1 Government revenues is a better indicator for measuring state capacity than government spending,because the increase in spending may be achieved by expanding the deficit without the increase in revenues.In a sense, we are looking at government expenditure that is backed by revenues and not by deficit financing.
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inequality, poverty and corruption are on the rise, the state needs more money, not less, to
bring these unfavourable developments to a halt.
Before transition in former socialist states, not only were government regulations
pervasive, but also the financial power of the state was roughly the same as in European
countries (government revenues and expenditure amounted to about 50% of GDP).
This allowed the state to provide the bulk of public goods and extensive social transfers.
During transition, tax revenues as a proportion of GDP decreased markedly in most
countries. However, Central European countries and Estonia managed to arrest the
decline, while Russia (together with Lithuania, Latvia and several South-East European
and Central Asian states) experienced the greatest reduction. In Vietnam the share
of government revenues in GDP grew by 1.5 times in 1989–93. Chinese government
revenues as a percentage of GDP fell by more than two times after the late 1970s, but
this appears more like a conscious policy choice rather than a spontaneous process
(authoritarian regimes always have better powers to collect tax revenues, if they choose
to do so, as did all governments in the centrally planned economies (CPEs) before
transition).
In most CIS states the reduction in government expenditure occurred in the worst
possible way—it proceeded without any coherent plan and did not involve the reassess-
ment of government commitments. Instead of shutting down completely some gov-
ernment programmes and concentrating limited resources on the others with an aim to
raise their efficiency, the government kept all programmes half-alive, half-financed and
barely working.
This led to the slow decay of public education, health care, infrastructure, law and order
institutions, fundamental research and development, etc. Virtually all services provided by
the government—from collecting custom duties to regulating street traffic—became
a symbol of notorious economic inefficiency. There were numerous cases of government
failure, which further undermined the credibility of the state since many government
activities in providing public goods were slowly dying and were only partly replaced by
private and semi-private businesses.
The dynamics of the government expenditure during transition seems to have been far
more important than the speed of reforms in shaping economic performance. In the words
of G. Kolodko, one of the architects of Polish economic reforms in 1994–2003, ‘there can
be no doubt that during the early transition there was a causal relationship between the rapid
Fig. 2. Consolidated government revenues and expenditure in Russia as a percentage of GDP.Source: EBRD Transition Report, various years.
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shrinkage in the size of government and the significant fall in output’ (Kolodko, 2000, p. 259).
Keeping the government big does not guarantee favourable dynamics of output, since
government spending has to be efficient as well. However, the sharp decline in government
spending, especially for the ‘ordinary government’ (see below), is a sure recipe to ensure
the collapse of institutions and the fall in output accompanied by the growing social
inequalities and populist policies.
When real government expenditure falls by 50% and more—as happened in most CIS
and South-East European states over a short period of time, just several years—there are
practically no chances to compensate the decrease in the volume of financing by the
increased efficiency of institutions. As a result, the ability of the state to enforce contracts
and property rights, to fight criminalisation, and to ensure law and order in general falls
dramatically (Popov, 2009A).
Thus, the story of the successes and failures of transition is not really the story of
consistent shock therapy and inconsistent gradualism. The major plot of the postsocialist
transformation ‘novel’ is the preservation of strong institutions in some countries (very
different in other respects—from Central Europe and Estonia to China, Uzbekistan and
Belarus2) and the collapse of these institutions in the other countries. At least 90% of this
story is about government failure (the strength of state institutions) and not about market
failure (liberalisation).
It is precisely this strong institutional framework that should be held responsible for both
the success of gradual reforms in China and shock therapy in Vietnam, where strong
authoritarian regimes were preserved and CPE institutions were not dismantled before
new market institutions were created, and for the relative success of radical reforms in EE
countries, especially in Central European countries, where strong democratic regimes and
new market institutions emerged quickly. And it is precisely the collapse of strong states
and institutions that started in the USSR in the late 1980s and continued in the successor
states in the 1990s that explains the extreme length, if not the extreme depth, of the FSU
transformational recession.
To put it differently, the Gorbachev reforms of 1985–91 failed not because they were
gradual, but due to the weakening of the state institutional capacity, which led to the
inability of the government to control the flow of events. Similarly, the Yeltsin reforms in
Russia, as well as the economic reforms in most other FSU states, were so costly not
because of the shock therapy, but due to the collapse of the institutions needed to enforce
law and order and carry out manageable transition.
Three major patterns of change in the share of government expenditure in GDP
generally coincide with the three major archetypes of institutional developments and, even
broader, with three most typical distinct ‘models’ of transition (Figure 3). The concept of
‘ordinary government’ (Naughton, 1997) makes a distinction between the state expendi-
ture directly contributing to the institutional capacity of the state (ordinary government)
and all other spending (transfers, subsidies, defence, debt service, etc.) that is not linked
directly to the institutional strength of the state. The intricacies of national statistics do not
2 Countries like Belarus and Uzbekistan fall into the same group as Central European countries andEstonia, with a small reduction in state expenditure as a % of GDP during transition, good quality ofgovernance, little bribery, small shadow economy and low state capture index (Hellman et al., 2000). In 2005Belarus and the Slovak Republic were the only two countries out of 25 surveyed in EE and FSU (BusinessEnvironment and Economic Performance Survey) where a significant improvement was registered in 2002–05 in all seven areas of economic governance (judiciary, fighting crime, combatting corruption, customs andtrade, business licensing and permits, labor regulations, tax administration) (EBRD, 2005).
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always allow spending for the ordinary government to be separated from the other outlays,
but even the rough comparison is telling (Figure 3).
Under strong authoritarian regimes (China) cuts in government expenditure occurred
at the expense of defence, subsidies and budgetary financed investment, while expenditure
for ‘ordinary government’ as a percentage of GDP remained largely unchanged; under
strong democratic regimes (Poland) budgetary expenditure, including that for ‘ordinary
government’, declined only in the pre-transition period, but increased during transition
itself; lastly, under weak democratic regimes (Russia) the reduction of the general level of
government expenditure led not only to the decline in the financing of defence, investment
and subsidies, but also to the downsizing of ‘ordinary government’, which undermined and
in many instances even led to the collapse of the institutional capacities of the state.
While in China total budgetary expenditure and that for ‘ordinary government’ were
much lower than in Russia and Poland, they were sufficient to preserve the functioning
institutions since the financing of social security from the government budget was
traditionally low. In Russia, however, although expenditure for ordinary government
seemed to have been not that much lower than in Poland, the pace of its reduction during
transition exceeded that of GDP: to put it differently, given the various patterns of GDP
dynamics, while in Poland ‘ordinary government’ financing grew by about one-third in real
terms in 1989–95/6 (and while in China it nearly doubled), in Russia it fell by about two-
thirds! The Russian pattern of institutional decay proved to be extremely detrimental for
investment and for general economic performance.
If the indicator of change in the share of state expenditure in GDP is added into
regressions explaining the output change during transition, it remains statistically
significant even after factoring in the conventional variables, such as the initial conditions
(per capita GDP before transition, and distortions in the industrial structure and trade
patterns inherited from central planning), the impact of wars and macroeconomic stability
Fig. 3. Government expenditure as a percentage of GDP.Source: Popov, 2000.
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(inflation rates) (see Popov, 2000, 2007). But it is apparent that the decline in the share of
government revenues in GDP was correlated with the decline in output during the
transformational recession (Figure 4).
Regressions tracing the impact of all mentioned factors are reported in Table 1 (Popov,
2000, 2007). After adding the decline in government revenues variable to the ones that
characterise the initial conditions (level of development and distortions) and the external
environment (war dummy variable), the explanatory power of the regression increases to
75%, with excellent T-statistics (28 observations). And it is quite remarkable that the
inclusion of liberalisation variables at this point does not improve the regression statistics.
Factoring in inflation allows the explanatory power to improve to 85%. The correlation
coefficient rises further, up to 90%, if other indicators of institutional capacities, such as
the share of the shadow economy, are added, though the number of observations in this
case is only 17 because of the lack of data (Popov, 2000).
To test the robustness of the results, another year for the end of the transformational
recession was chosen (1998), so the period considered was 1989–98 (by the end of 1998
the absolute trough was reached in 24 countries out of 26 that experienced the recession).
The adjusted R2 is slightly lower, but the statistical significance of the coefficients remains
high (with the exception of the initial GDP per capita). The best equation is shown below
(Popov, 2007):
LogðY98=89Þ5 5:82 0:006DIST 2 0:005Ycap872 0:39WAR2 0:01GOVREVdecline2 0:17logINFL 2 003DEM
(22.48) (20.09) (23.22) (22.94) (24.60) (21.74)
Where N 5 28 and the adjusted R2 5 82%. The T-statistics are shown in brackets and all
variables are presented in the same order as in Table 1. DEM is the average score of the
political rights index from Freedom house.
Once again, if the liberalisation variable is introduced into this equation, it turns out to
be insignificant.
In general, from all points of view, the dynamics of the government expenditure during
transition seems to have been by far the more important factor for successful trans-
formation than the speed of reforms. Keeping the government big does not guarantee
favourable dynamics of output, since government spending has to be efficient as well.
Fig. 4. Change in government revenues and GDP.Source: Popov, 2000.
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However, the sharp decline in government spending, especially for the ‘ordinary
government’, is a sure recipe to ensure the collapse of institutions and the fall in output
accompanied by the growing social inequalities and populist policies.
China seems to be an exception to this rule, since there was no transformational
recession in China although the share of government spending in GDP fell from 35% in
1978 to 13% in the mid 1990s. However, firstly, the major decrease occurred in the second
half of the 1980s, whereas in the first stage of transition the government spending grew
pretty much in line with GDP. Secondly, the decrease in the share of state expenditure was
a controlled process, i.e. it occurred due to the initiative of the government itself, not
despite its efforts. Thirdly, the expenditure for the ‘ordinary government’ (excluding
subsidies, investment and defence spending) grew in line with GDP. Lastly, since 1995 the
share of state expenditure in GDP in China has increased (about 20% in 2010).
3. Consequences of downsizing
The collapse of the institutional capacity of the state was the prime reason for the
transformational recession that on average resulted in a loss of 20 years of economic
development for most post-Soviet states—ten years of the reduction of output and another
ten years of the subsequent recovery to the pre-recession level (Figure 5). Dramatic as they
were (larger than the Great Depression), these economic costs came together with a huge
social price to pay.
Table 1. Two stage least squares robust estimates: regression of change in GDP in 1989–96 on initialconditions, institutional capacity, liberalisation and rule of law and democracy indices (liberalisationindex instrumented with the democracy level variable)
Equations; number ofobservations/variables
1,N 5 28
2,N 5 28
3,N 5 17
4,N 5 17
Constant 6.4*** 6.3*** 6.0*** 6.0***Pre-transition distortions,
% of GDP20.01*** 20.02*** 20.004
1987 purchasing power parity GDP per capita,% of US level
20.007** 20.01**
War dummya 20.45*** 20.29b
Liberalisation index in 1995 20.18** 20.39* 20.19*** 20.19***Decline in government revenues
as a % of GDP from 1989–91 to 1993–9620.02*** 20.02***
Log (inflation, % a year, 1990–95,geometric average)
20.17*** 20.22*** 20.22*** 20.19***
Rule of law index, average for 1989–97, % 20.01c
Increase in the share of shadow economyin GDP in 1989–94, p.p.
20.02*** 20.015***
R2, % 86 77 88 90
Notes: Dependent variable 5 log (1996 GDP as a % of 1989 GDP). For China, all indicators are for theperiod 1979–86 or similar.*, **, ***Indicate significance at 1%, 5% and 10% level, respectively.aEquals 1 for Armenia, Azerbaijan, Croatia, Georgia, Macedonia and Tajikistan, and 0 for all other countries.bSignificant at 12% level.cSignificant at 16% level.
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Education and health care were free in the Soviet Union, but now these services are
provided mostly for a fee and their quality is way below Soviet standards. Life expectancy
declined from 70 years in 1987 to 64 years in 1994 and then recovered only to 68 years in
2010 (against 73 years in China). Criminalisation of the country made a mockery out of the
idea of law and order. The shadow economy and corruption increased; income inequalities
grew.
In 1980–85 the Soviet Union was placed in the middle of a list of 54 countries rated
according to their level of corruption, with a bureaucracy cleaner than that of Italy, Greece,
Portugal, South Korea and practically all the developing countries. In 1996, after the
establishment of a market economy and the victory of democracy, Russia came in 48th in
the same 54-country list, between India and Venezuela (Internet Center for Corruption
Research, http://www.icgg.org/corruption.cpi_olderindices_overview.html, date last ac-
cessed 22 December 2011) (Figure 6).
The shadow economy, which the most generous estimates place at 10%–15% of the
GDP under Brezhnev, grew to 50% of the GDP by the mid 1990s (Kaufmann and
Kaliberda, 1996). Virtually everywhere in the transition world the reduction of govern-
ment spending was accompanied by an increase in the share of the shadow economy
(Figure 7). Normally in market economies there is a positive correlation between the level
of taxation, the share of government revenues in GDP and the size of the shadow economy:
if taxes are excessive, economic agents tend to avoid taxation through underground
Fig. 5. GDP change in FSU economics, 1989 5 100%.Source: EBRD Transition Report, various years.
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activity, including non-reported barter operations (Gardner, 1988, p. 24). In transition
economies the opposite is true: the lower the state revenues, the larger is the shadow
economy (Figure 7). In fact, there was a nearly one-to-one crowding out effect: for every 1
p.p. of the reduction of the share of state revenues in GDP, the share of the shadow
economy increased by 1 p.p. To put it differently, the dynamics of the share of government
revenues in GDP in transition economies is a rather accurate measure of the ability of the
state to enforce rules and regulations.
Equally unpleasant was the accompanying increase in income inequalities. Only
countries with the lowest decline of the share of state spending in GDP (Central Europe,
Estonia, Uzbekistan and Belarus) managed to keep the increases in inequalities within
reasonable limits. In turn, the increase in income inequalities had a detrimental effect on
economic growth, because it contributed to social tensions and worsened the investment
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Fig. 6. Corruption perception indices.Source: Transparency International.
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Government spending as a% of GDP in 1993-96.
Poland
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Fig. 7. Government expenditure and shadow economy as a percentage of GDP.Source: Johnson et al., 1997.
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climate (Alesina and Perotti, 1996; Alesina and Rodrik, 1994), and because it created
lobbies that opposed structural reforms and macrostabilisation (Fernandez and Rodrik,
1991; Persson and Tabellini, 1994). Besides, social inequalities created grounds for
macroeconomic populism—the redistribution of funds from winners to losers, from
competitive to non-competitive sectors, from rich to poor (Kaufman and Stallings, 1991):
the greater were the income inequalities, the stronger was the lure to redistribute the
economic pie instead of increasing it.
Worst of all, the criminalisation of the Russian society grew dramatically in the 1990s.
Crime had risen gradually in the Soviet Union since the mid 1960s, but after the collapse of
the USSR there was an unprecedented surge—in just several years in the early 1990s crime
and murder rates doubled and reached one of the highest levels in the world.3 By the mid
1990s the murder rate stood at over 30 people per 100,000 inhabitants (Figure 8) against
one to two persons in Western and Eastern Europe, Canada, China, Japan, Mauritius, and
Israel. Only two countries in the world (not counting some war-torn, collapsed states in
developing countries) had higher murder rates—South Africa and Colombia—whereas in
countries like Brazil or Mexico this rate was two times lower. Even the US murder rate, the
highest in developed world—six to seven people per 100,000 inhabitants—pales in
comparison with the Russian one.
The Russian rate of deaths from external causes (accidents, murders and suicides) had,
by the beginning of the twenty-first century, skyrocketed to 245 per 100,000
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Fig. 8. Crime rate (left scale), murder rate and suicide rate (right scale) per 100,000 inhabitants.Source: Goskomstat.
3 Crime statistics are usually perceived to be incomparable for different countries because of largevariations in the percentage of registered crimes, but murders are registered quite accurately by bothcriminal and death demographic) statistics. The former are more restrictive than the latter, since theyregister only illegal murders, whereas demographic figures cover all murders, including ‘legal’ ones—capitalpunishment and ‘collateral damage’ during wars, and anti-terrorist and other police operations. Both ratesskyrocketed in Russia at the beginning of the 1990s and remain at extremely high levels. The gap betweenthese two indicators widened during the first and second Chechen wars (1994–96 and 1999–2002); seeFigure 8.
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inhabitants. It was higher than in any of the 187 countries covered by World Health
Organization estimates in 2002—equivalent to 2.45 deaths per 1,000 a year, or 159 per
1,000 over 65 years, which was the average life expectancy in Russia in 2002. Put
differently, if these rates were to continue to hold, one out of six Russians born in 2002
would have an ‘unnatural’ death. Certainly, in the 1980s the murder, suicide and
accidental death rates were already quite high in Russia, Ukraine, Belarus, Latvia, Estonia,
Moldova and Kazakhstan—several times higher than in other former Soviet republics and
in East European countries. However, they were roughly comparable to those of other
countries with the same level of development. In the 1990s these rates rapidly increased, far
outstripping those in the rest of the world.
The mortality rate grew from ten per 1,000 in 1990 to 16 in 1994, and stayed at a level of
14–16 per 1,000 thereafter. This was a true mortality crisis—a unique case in history,
where mortality rates increased by 60% in just five years without any wars, epidemics or
eruptions of volcanoes (Popov, 2010). Never after the 1947 famine had Russia had, in the
postwar period, mortality rates as high as those in the 1990s.4 Even in 1950–53, during the
last years of Stalin’s regime, with the high death rates in the labour camps and the
consequences of the wartime malnutrition and wounds, the mortality rate was only nine to
ten per 1,000, as compared with 14–16 in 1994–2008 (Figure 9).
The Russian human development index (computed as the average of three indicators
calibrated from 0 to 100 : purchasing power parity GDP per capita, life expectancy and
educational level) did not increase for the whole period of the 1990s, and fell below the
level of Cuba and probably that of China (Figure 10).
Russia became a typical ‘petrostate’. Few specialists would call the USSR a resource-
based economy, but Russia’s industrial structure changed considerably after the transi-
tion to the market. For all intents and purpose, the 1990s were a period of rapid
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itan
ts
63
64
65
66
67
68
69
70
Averag
elife
exp
ectan
cy,years
Mortality
(left scale)
Life expectancy (right scale)
Fig. 9. Source: Goskomstat.
4 The author is grateful to the anonymous referee who pointed out that in 1947 mortality was 17 per 1,000(as estimated in Andreev et al., 1998, p. 165).
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deindustrialisation and ‘resourcialisation’ of the Russian economy, and the growth of world
fuel prices since 1999 seems to have reinforced this trend. The share of output of the major
resource industries (fuel, energy and metals) in total Russian industrial output increased
from about 25% in the late 1980s to over 50% by the mid 1990s and stayed at this high
level thereafter. This was partly the result of changing price ratios (greater price increases
in resource industries), but it was also due to the fact that the real growth rates of output
were lower in the non-resource sector. The share of mineral products, metals and
diamonds in Russian exports increased from 52% in 1990 (USSR) to 67% in 1995 and to
81% in 2007, whereas the share of machinery and equipment in exports fell from 18% in
1990 (USSR) to 10% in 1995 and then to below 6% in 2007.
The share of spending in research and development was 3.5% of GDP in the late 1980s
in the USSR. It had fallen to 1.1% in Russia by 2007 (compared with: China, 1.3%; the
USA, Korea and Japan, 2%–3%; Finland, 4%; and Israel, 5%). So today’s Russia really
looks like a ‘normal’ resource-abundant developing country (Figure 11).
Income inequalities increased greatly: the Gini coefficient increased from 26% in 1986
to 40% in 2000 and then to 42% in 2007–10 (Figure 12). The decile coefficient—the ratio
of incomes of the wealthiest 10% of the population to the incomes of the poorest
10%—increased from 8 in 1992 to 14 in 2000 and then to 17 in 2007–10.
But the inequalities at the very top increased much faster: in 1995 there was no person in
Russia worth over US $1 billion; in 2007, according to Forbes, Russia had 53 billionaires,
which propelled the country to second or third place in the world in this regard after the
USA (415) and Germany (55) (Figure 13). Indeed, Russia had two fewer billionaires than
Germany, but Russia’s billionaires were worth a total of US $282 billion (US $37 billion
more than Germany’s richest). In 2008, the number of billionaires in Russia increased to
86, with a total worth of over US $500 billion—a full one-third of the national GDP. The
Soviet Union was abnormal in that it had no billionaires at all and there were hardly even
dollar millionaires (perhaps only a dozen—in the shadow economy). In March 2011, when
Russian GDP had not yet recovered to the pre-recession 2008 level, the number of
billionaires exceeded 100. Whereas China surpassed Russia in the billionaire headcount
0.63
0.68
0.73
0.78
0.83
1990 1992 1994 1996 1998 2000 2002 2004 2006
Cuba
Belarus
Russia
Ukraine
China
Fig. 10. Human development index for Belarus, China, Cuba, Russia and Ukraine.Source: Human Development Report.
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(116), it was still behind Russia in terms of total wealth of billionaires (Forbes web site,
http://www.forbes.com/wealth/billionaires).
4. State capacity at the recovery stage (1998–2008)
At the recovery stage (1998–2008) the state capacity strengthened, but not much (Popov,
2004). The lack of state capacity continued to be the major constraint for better economic and
social performance. Cross-country comparisons show that indicators that determine in-
stitutional capacity—such as the rule of law index (positively) and the decline in the ratio of
government revenues in GDP (negatively)—continued to affect performance during the
recovery in the same way they affected performance during the transformational recession
(Popov, 2007).
The paradox of the first decade of the twenty-first century in Russia was that the country
was getting huge windfall revenues from oil and gas exports at exceptionally high prices,
but these revenues bypassed the state coffers (because the government decided to cut tax
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
5
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Israel
Finland
Japan
Korea, Rep.
United States
Germany
United Kingdom
China
Russian Federation
India
Fig. 11. Research and development in selected countries as a percentage of GDP.Source: World Development Indicators database, World Bank.
Fig. 12. Gini coefficient of income distribution in China and Russia, 1978–2006.Source: Goskomstat; Chen et al., 2008.
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rates) and precipitated to households and companies (real personal incomes nearly
doubled in 1999–2005), even though the weakest link and the bottleneck of the economic
and social situation was the lack of state institutional capacity. Why was the government
missing such a favourable chance to restore its institutional capacity?
The explanation of the liberal economists and some officials was that the governments
at all levels (regional and national) were corrupt and could not spend additional money
without embezzling it. Instead of increasing government spending, they suggested raising
the efficiency of the government spending, in particular through the reform of public
administration. It sounded like a good idea, but for over a decade before that there was no
improvement in government efficiency, only deterioration. And of course the increase in
efficiency did not come this time. On the contrary, public administration reform required
increased spending—higher salaries for bureaucrats and judges to make them ‘corrup-
tion proof’, and higher spending on control and accounting bodies, and on the
investigation and prosecution of fraud and abuse activities.
The argument that Russia was not rich enough to fix its education, health care, public
administration, law and order missed the point. There were many countries no richer than
Russia, from Cuba to Belarus, where life expectancy was longer, crime rates were lower
and bureaucracy was cleaner.
In short, the increase in government spending could lead to both a more efficient
government administration and greater volumes of public goods, but the government
failed to channel the stream of petrodollars into repairing the ‘weakest link’ of the national
economy—the provision of public goods and investment into non-resource industries.
Investment and government consumption amounted to about 50% of GDP in the early
1990s, fell to below 30% of GDP in 1999 (right after the 1998 currency crisis) and
recovered only partially afterwards, to about 40% of GDP in 2007.
Fig. 13. Number of billionaires in 2007 and purchasing power parity GDP in 2005 (billion US$) bycountry. Source: Forbes website and World Development Indicators.
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Instead of using windfall petrodollars to repair the weakest link—state capacity to
provide public goods—the government, on the one hand, decreased tax rates, allowing
petrodollars to leak into personal incomes, and, on the other, maintained a budget surplus
that expanded to nearly 10% of GDP (Figure 2) and was used to finance the accumulation
of foreign exchange reserves in the central bank and the stabilisation fund.
5. 2008–09 recession
The world economic recession hit Russia harder than other countries due to the fall in oil
prices in 2008–09, the outflow of capital caused by world recession and the poor policies to
cope with the double (trade and financial) shock. The reduction of GDP in 2009 totalled
7.9%, as compared with 2.5% in the USA, 4.1% in the European Union and 5.2% in
Japan. Most developing countries, however, did much better than developed countries.
China grew at 8.7%, India by 5.7%, the Middle East by 2.4% and Sub-Saharan Africa by
2.1%. Only economies of Latin America, Eastern Europe and the former Soviet Union
contracted by 1.8%, 3.7% and 6.6%, respectively.
Luckily, the Russian government had a surplus budget (due to high oil prices) for the most
part of the first decade of the new century, so when revenues fell (due to a fall in oil prices)
there was some room to increase expenditure and the deficit. Total government spending
increased in 2009 in real terms and grew from 34% of GDP to over 40% (Figure 14), which
helped stabilise the economy.
It is worrisome, though, that the increase in government spending was short lived and
came to an end once the recession was over in 2009. It was planned to reduce government
spending to 36% of GDP by 2013 (Table 2).
The reason why the Russian 2008–09 recession was so deep despite the steep increase in
government spending was associated with the restrictionary monetary policy: when the
Russian central bank faced the adverse trade shock and the outflow of capital in 2008–09, it
reacted not so much by allowing the ruble to devalue, but by allowing foreign exchange
reserves to drop (from nearly US $600 in August 2008 to US $376 billion in March 2009),
which led to a decline in money supply (Figure 15) and to an increase in interest rates
(Figure 16)—unfortunate developments that aggravated the recession.
A similar development—excessive monetary austerity—was observed in 1997–98, right
before the currency crisis of August 1998. Then, the reduction in output started in late
10
15
20
25
30
35
40
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Consolidated budget
Federal budget
Revenues
Expenditure
Expenditure
Revenues
Fig. 14. Government budget revenues and expenditure as a percentage of GDP, Minfin data.Source: Department of Finance of RF.
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1997 and continued until the devaluation of August 1998 (Figure 17). It is a textbook case
of a recession that was manufactured by wrong macroeconomic policy: tight monetary
policy designed to stop the outflow of capital and to prevent the devaluation of the
overvalued exchange rate (Montes and Popov, 1999; Popov, 2009B).
The transition economies—the newcomers to the capitalist world—were hit especially
hard by the boom and bust cycle—the increase in capital inflow in 2002–07 and the
outflow of capital in 2008–09. In most cases they abolished controls over cross-border
capital flows in the 1990s and did not restore them after the Asian financial crisis of 1997.
There is evidence that this policy of monetary austerity aggravated the recession in
quite a number of countries (Popov, 2011). The Baltic states (Estonia, Latvia and
Lithuania), for instance, experienced the greatest reduction in output in 2007–09 (from
12% to 22%) not because of trade and capital account shocks—which were not that
large (2% of GDP)—but mostly due to the policy to maintain the exchange rates of their
currencies (Estonia and Lithuania run formal currency boards and Latvia has a de facto
currency board). The outflow of capital of about 4% of GDP (partially counterweighted by
the improvement of the trade balance of about 2% of GDP) led to the reduction of
Table 2. The government’s medium-term fiscal framework (percentage of GDP)
Budgetary items 2009 2010 2011 2012 2013
Revenues (consolidated) 34.3 35.3 34.8 34.0 33.2Of which federal budget 18.8 18.7 17.6 17.0 16.8Expenditures (consolidated) 40.5 38.9 38.9 37.6 36.3Of which federal budget 24.6 22.7 21.1 20.1 19.7Federal budget non-oil deficit 213.5 212.7 211.6 210.5 29.8Federal budget balance 25.9 24.1 23.5 23.1 22.9Consolidated budget balance 26.2 23.6 24.2 23.6 23.1
Source: Ministry of Finance.
Fig. 15. Money supply in Russia before and during the 2008–09 recession, billion rubles.Source: Central Bank of Russia.
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foreign exchange reserves, which under the regime of a currency board automatically
translated into a decline in the money supply (Figure 18)—very much like the outflow of
capital from Argentina in 2000–02 (which also had a currency board at the time) caused
a recession (Popov, 2011).
On the other hand, the expansionary effect of devaluation is limited, of course. If the
negative trade and capital account shocks are too large, devaluation cannot mitigate
these shocks completely, but only triggers inflation. Some countries (Russia and
Bulgaria, for instance) experienced a combined trade and capital account shock of the
magnitude of 7% of GDP (deterioration of the trade and capital account balance in
Fig. 16. Interest rates in Russia in 2008–09, %. Source: Central Bank of Russia.
83
88
93
98
103
19
96
.1
19
96
.4
19
96
.7
19
96
.10
19
97
.1
19
97
.4
19
97
.7
19
97
.10
19
98
. 1
19
98
. 4
19
98
.7
19
98
.10
19
99
.1
19
99
.4
19
99
.7
19
99
. 10
Devaluation
Fig. 17. Monthly index of industrial production with seasonal corrections, 1995 5 100%.Source: Goskomstat.
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Q3–4 2008 and Q1 2009 (average of 3 quarters) as compared to Q2 2008. Even though
these countries did not finance these shocks completely by running down their reserves
(they fell only by about 3% of GDP per quarter), but also devalued their national
currencies, they were not able to avoid the reduction in output that became one of the
largest in the world.
The regression equation that best explains the decline in output in 2007–09 (or in 2009
alone) is as follows (T-statistics in brackets):5
Yincr07209 5 1:8 2 1:3CAPinflQ2 2 2:1TRbalINCRQ2 1 1:9FORincrQ3
(2.38) (23.36) (24.55) (3.93)
Number of observations 5 92, R2 5 0.1788, robust standard errors,
where: Yincr07_09 is the GDP change in 2007–09; CAPinflQ2 is the increase in capital
inflow from Q2 2008 to the average for Q3–4 2008 and Q1 2009 (% of 2008 GDP);
TRbalINCRQ2 is the increase in the trade balance from Q2 2008 to the average for Q3–4
2008 and Q1 2009 (% of 2008 GDP); and FORincrQ3 is the average quarterly increase in
foreign exchange reserves in Q3–4 2008 and Q1 2009 (% of 2008 GDP).6
It implies that negative shocks to the capital account (as well as to the trade account) do
not lead to a decline in GDP growth rates if foreign exchange reserves do not decline
proportionately, i.e. if the shock is absorbed by devaluation and not by running down the
reserves.
Fig. 18. Growth rates of money supply (M2 ) in the Baltic states, %.Source: World Development Indicators.
5 This and other equations work if changes in GDP are measured by the 2009 growth rate alone (not2007–09), and also if changes in capital and trade shocks are measured as the difference between averagevalues for Q2–3 2008 and Q4 2008–Q1 2009, whereas changes in reserves are computed as the averagequarterly change for the period Q4 2008–Q1 2009 (see Popov, 2011 for details).
6 Note that the sum of CAPinflQ2 and TRbalINCRQ2 is not equal to the increase in the foreign exchangereserves in any particular quarter. Changes in trade balance and capital flows are measured as seconddifferences (increase from Q2 2008 to the average quarterly level of Q3–4 2008 and Q1 2009), whereas theincrease in reserves over the same period is measured as the first difference (average increase from thebeginning of the quarter to an end of the quarter).
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6. Conclusions
Wassily Leontief (1974) once noted that an economy using the profit motive but without
planning is like a ship with a sail but no rudder. It may move rapidly, but cannot be steered
and might crash into the next rock. A purely planned economy that has eliminated the
profit motive is like a ship with a rudder but no sail. It could be steered exactly where one
wants it to go, if only it moved. To move forward while avoiding dangerous pitfalls, an
economy needs both some reliance on the profit motive and some planning, i.e. a sail and
a rudder.
Similarly, Holmes (1997) claims that the major lesson to be learned by Western
democracies from recent Russian developments is exactly the one about the crucial
importance of state institutions: whereas the Soviet Union proved that a non-market
economic system with the strongest state cannot be efficient, Russia today is proving that
a market without a strong state degrades to the exchange of unaccountable power for
untaxable wealth, which leads to economic decline.
It was argued in earlier papers that the collapse of output during transition was caused
primarily by several groups of factors (Popov, 2000, 2007). First, by greater distortions in
the industrial structure and external trade patterns on the eve of the transition. Second, by
the collapse of state and non-state institutions, which occurred in the late 1980s to early
1990s and which resulted in chaotic transformation through crisis management instead of
organised and manageable transition. Third, by poor economic policies that basically
consisted of bad macroeconomic policy and import substitution industrial policy. Lastly,
the speed of the reforms (economic liberalisation) affected the performance negatively at
the stage of the reduction in output, because enterprises were forced to restructure faster
that they possibly could (due to limited investment potential), but positively at the recovery
stage.
This second reason—the institutional collapse—is largely responsible for the extreme
depth of the transformational recession; here differences between the EE countries and the
FSU are striking. The adverse supply shock in this case came from the inability of the state
to perform its traditional functions—to collect taxes and to constrain the shadow economy,
to ensure property and contract rights, and law and order in general. Naturally, poor ability
to enforce rules and regulations did not create a business climate conducive to growth and
resulted in increased costs for companies.
The trick of transition, as is evident post factum, was not to carry out economic
liberalisation, but to carry it out in such a way as not to throw away the baby with the
bathwater, i.e. not to squander the precious achievements of the previous communist
period in the form of strong institutions. China generally did not squander this heritage,
even though government spending fell, income inequalities rose and crime rates increased,
whereas Russia and most other CIS states did.
The reforms that are needed to achieve success are different for countries with different
backgrounds. Manufacturing growth is like cooking a good dish—all the required
ingredients should be in the correct proportion; if only one is under- or over-represented,
the ‘chemistry of growth’ would not happen. Fast economic growth can materialise, in
practice, only if several necessary conditions are met simultaneously. Rapid growth is
a complicated process that requires a number of crucial inputs—infrastructure, human
capital, even land distribution in agrarian countries, strong state institutions and economic
stimuli, among other things. Once one of these crucial necessary ingredients is missing, the
growth just does not take off. Rodrik et al. (2005) discuss ‘binding constraints’ that hold
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back economic growth; finding these constraints is the task of ‘growth diagnostics’. In some
cases these constraints are associated with a lack of market liberalisation, in others they are
associated with a lack of state capacity, human capital or infrastructure.
Why did economic liberalisation work in Central Europe but not in SSA and Latin
America (LA)? The answer, according to the outlined approach, would be that in Central
Europe the missing ingredient was economic liberalisation, whereas in SSA and LA there
was a lack of state capacity, not a lack of market liberalisation. Further, why did
liberalisation work in China and Central Europe but not in CIS? The answer is that in
the CIS it was carried out in such a way as to undermine the state capacity—the precious
heritage of its socialist past—whereas in Central Europe and even more so in China the
state capacity did not decline substantially during transition (Lu, 1999). The reduction of
government expenditure as a share of GDP did not significantly undermine the
institutional capacity of the state in China, but in Russia and other CIS states it turned
out to be ruinous.
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