11.1 Shock therapy

Where should the great transformation begin? Yeltsin and his advisers understood that the Soviet Union failed because it could not create and manage a modern economy. The political obstacles to carrying out radical reforms at least temporarily disappeared, and thanks to Gorbachev’s policies for alleviating tensions, the international environment was unthreatening. Economic problems had to be tackled immediately.

Unlike the cautious Gorbachev, Yeltsin listened to economists, foremost among them Yegor Gaidar, who believed in what came to be called “shock therapy.” The changes that these people were willing to introduce were every bit as revolutionary as what had happened in 1917 or at the time of collectivization. The principle of the radical economists was simple: the old regime had to be destroyed at once and unrestricted capitalism had to be introduced. Just like the Bolsheviks in 1917, they were guided by an ideology, in this case the ideology of unfettered capitalism. They saw that the half measures introduced during the Gorbachev era had brought no positive results. They understood that the radical steps they proposed would cause social pain and therefore political danger in the short run, but they believed that there was no alternative. Russia was in a crisis: the Soviet-type economy could function only as long as there was a coercive regime in power. Once that collapsed, anarchy threatened. The government was once again in danger of not being able to feed the cities. Since the government could not use coercion, the peasants saw no need to sell their products for an increasingly worthless currency when there was nothing to buy in the shops in any case. It was ironic that sixty years earlier, the government had responded to its inability to provide bread for the cities by suspending the market mechanism at the heart of the NEP. Now the reaction to the same problem was an attempt to reintroduce the market by making prices realistic. As collectivization was driven by an ideology, so was the introduction of shock therapy. Both produced foreseeable misery in the short run, in hopes of great improvement in the future.

It strengthened the resolve of the reformers that shock therapy seemed to be working in another post-communist country, Poland. However, Russia’s difficulties were of a different order of magnitude: the old centralized system based on state ownership and central planning had ceased to function and there was nothing to take its place. The Soviet Union had had a highly centralized economy: in many cases a product had been produced in only one factory and now that factory was beyond the newly drawn borders. The close economic ties between the Soviet Union and the rest of Eastern Europe were broken. What the Soviet Union could acquire in the past from the satellites in a barter system now had to be paid for with convertible currency. The newly independent republics started to print rubles, and Russia was in danger of being flooded with worthless money. The success of economic stabilization necessitated breaking up the ruble zone. In this period of transformation the country had neither a functioning banking system nor a convertible currency.

Just as importantly, Russia lacked a reliable system of commercial law and judiciary that could enforce contracts. Factory directors who had operated in a very different economic system could hardly be expected to understand the principles of the market and to act accordingly from one day to the next. Perhaps understandably, as human beings everywhere, the directors were above all interested in serving their own interests, and whenever possible they took advantage of opportunities to enrich themselves. But most damaging for the cause of reform, unlike in the countries of East Central Europe and the newly independent Baltic states, there was no broad consensus in favor of thoroughgoing change. Public opinion surveys at the time showed that the majority of Russians had a negative attitude toward private property.

What did shock therapy mean in practice? The average person first noticed the freeing of prices, in other words an enormous increase in the cost of everything. A few exceptions remained: the price of bread and transport, at least for a short time, remained controlled, that is, subsidized. (Already in March 1992, under pressure from conservatives, the government abandoned plans to free the domestic price of oil, which was about one percent of the world market price. This concession later allowed extraordinary corruption: some well-connected domestic oil traders bought and resold domestic oil on the world market and made fabulous profits.) In the Soviet era prices had been officially and therefore artificially set and had little relation to the cost of production. The distribution of scarce goods had been resolved not by adjusting prices but by constant shortages, which had required ordinary citizens to stand in line for scarce goods. At the end of the Gorbachev era shops often stood empty. Since there was little to buy that customers actually wanted, even people with modest incomes had substantial savings. The immediate and foreseeable consequence of freeing prices was a steep and sudden inflation: a great deal of accumulated money chased too few available goods. Within a year prices rose 2600 percent. Inflation eliminated savings. Old people on pensions were particularly hard hit; those who had saved for their old age and kept their money under a mattress rather than in a Soviet bank were financially wiped out practically over night. On the other hand, those who had opportunities could benefit handsomely. The minor social revolution caused by inflation turned many Russians against the reformers.

Another part of shock therapy was a half-hearted attempt at withdrawing support from enterprises that were still owned by the state. According to the principles of market economics, the vast majority of factories operated at a loss. If the government wanted to eliminate the deficit and build a realistic budget, it could no longer afford to subsidize inefficient enterprises. A realistic budget was essential to make the currency convertible and thereby enable Russia to participate in the world economy and attract much needed foreign investment. However, to implement the plans fully would have meant shutting down thousands of factories, creating an army of unemployed. Yeltsin recoiled from the consequences, and therefore, in this matter, Gaidar did not fully prevail.

At the heart of shock therapy was privatization. The state had to get out of the business of running the economy. But how to accomplish this in a country where people did not have the capital and there were no managers capable of operating in the new system? Another fundamental problem was the impossibility of appraising national property fairly. Privatization was an enormously complex, difficult, and drawn-out process that went through several stages. The goal of the government was not for the state to receive fair compensation for the factories and mines, which was considered impossible, but rather to create efficient enterprises and a shareholder society. The government achieved neither goal. The process lacked transparency, corruption was rife, and privatization understandably and justifiably did not inspire confidence among the Russian people.

Gaidar’s initial solution was to give every citizen a voucher worth 10,000 rubles, at that time approximately $22, to enable them to buy stocks for that value. The intention was to make Russian citizens share owners, that is, property owners with an immediate financial interest in running enterprises. Often the workers invested their vouchers in the company where they worked. The vouchers provided yet another opportunity to make money dishonestly. Enterprising people advertised in newspapers, promising great returns on investment based on vouchers, and set up pyramid schemes to take advantage of the gullible. Some succeeded in collecting millions and then escaping from Russia. The scandals that followed, discussed at length in newspapers, further undermined the faith of Russians in the economic reforms. Soon the shares lost even their small face value and were traded in the streets for a pittance.

No privatization has ever been without corruption. Even in England in the days of Margaret Thatcher, when state-owned companies were privatized, insiders or people with useful contacts unfairly benefited. In the Russian case the possibilities were infinitely greater, and therefore so was corruption. Those who had the opportunity could take control of enterprises for private gain. Instead of running the enterprises for the possibility of some future profit, the new owners, who could not be confident of their property rights, attempted to benefit as quickly as possible, often by selling the assets of the enterprises they had acquired. In theory, the workers who had stocks in the companies where they worked could have exercised oversight over the management, but in reality that almost never happened. One of the schemes factory managers concocted was to get government loans to pay their workers, but given the extraordinary inflation, they immediately turned the rubles into dollars. Then weeks later, they bought back cheaper rubles with which they paid their workers overdue and worthless wages, pocketing large sums themselves. The unfairness and criminality inherent in this system were undermining the already small respect for the processes of democratization and economic change. The national wealth quickly came to be concentrated in a very few hands. This was harmful not only from a political and social point of view but also from the point of view of economics. Because of the highly concentrated wealth, neither a modern stock market nor a functioning banking system could develop.

The second stage of privatization, which took place in 1995–96, was even more rife with corruption than the first. The state desperately needed money, so it entered into a relationship with groups of oligarchs in the banking and raw material sections of the economy. This entailed shares of large enterprises that were still owned by the state be given as collateral in exchange for loans that were never expected to be repaid. In this way groups of rich people came into possession of even greater wealth. Political power, influence, and wealth came to be even more intertwined.

One would think that privatization in agriculture would be easier. Given the resistance of peasants to collectivization sixty years earlier, it seemed reasonable to expect that once the peasants were given the opportunity to cultivate their own land they would enthusiastically take advantage of it. It did not turn out this way. Although there were no more legal obstacles for private ownership of land, the peasants were reluctant to buy land at a time when agriculture was increasingly unprofitable, given the cheap Western imports and gradually increasing energy costs. Agriculture, the stepchild of Soviet industry, did not become more productive. On the contrary, in the 1990s, the crucial grain harvest fell by almost half, and the situation was even worse in the output of milk and meat. As a result of the reforms, the gap in the standard of living between people living in the countryside and those in the major cities further widened.

In contrast to Russia, land reform was highly successful in China. Perhaps because the Chinese peasants had been even poorer and more miserable than the Russians, they embraced privatization with enthusiasm, and the greatly increased agricultural productivity became the basis of the Chinese “economic miracle.”

The Russian reforms could not achieve their goal; a functioning market-driven economy remained elusive. The necessary restructuring did not take place, and factories continued to demand and receive subsidies. Given the precarious nature of the Russian economy, the newly rich found it better and safer to keep their money abroad. When investment capital was urgently needed, far more money left the country than was received in foreign investment. Nor did the country become a society of small property owners. The reformers had imagined that shareowners would become partisans of the new state, based on a capitalist economy. In this they were disappointed. Russia did not become a society of small capitalists.

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