- The Washington Times - Sunday, June 4, 2000

I recently sat down with the new president of Russia, Vladimir Putin, culminating a visit by nine economists from four nations invited by high-level Russian officials to consult on economic reforms. Mr. Putin has his hands full, but the prospects for economic reform in Russia are good.

In many ways, the Russian economy is in a mess. Official gross domestic product in 1999, measured by exchange rates, is about what the U.S. produces in a week. After allowing for considerable non-cash and illegal operations and using the purchasing power parity approach, Russia's GDP is still smaller than that of Canada, a nation with one-fifth the population.

Unemployment is well into double digits, inflation in 1999 was about 85 percent, much activity is conducted using barter, and a big problem of non-paid wages and business obligations exists. The commercial banking system is barely functioning. Russian banks make almost no loans to private businesses or individuals. Some regional governments are operating almost like feudal fiefdoms, and bribes and corruption are widespread. Foreign debt is huge and international business confidence in Russia is almost nil. Capital still is fleeing the country.

Despite all of this, there are grounds for cautious optimism about the Russian economy. Our group met with top officials, and was extremely impressed at their commitment to reform. Mr. Putin's personal economic adviser, Andrei Illarionov, is young, brilliant and well-trained in the classical liberal Western tradition, as expressed in the Austrian, Chicago and public choice schools of economics. The Gref Center, the think-tank in Russia officially responsible for devising a reform plan, seems to be relatively market-oriented as well, as are many reformists from the Yeltsin days. The Duma (Russian Parliament) is expected to buy into at least a large part of a reform package, and reformists seem determined to deal with corrupt regional oligarchs and politicians, not to mention lethargic bureaucrats.

Conditions are already improving. Real GDP is estimated to have risen more than 3 percent in 1999, and is growing even faster this year. Inflation may be in the single digits for the year. A huge trade surplus exists in part because of a favorable real exchange rate, increasing international reserves. Capital flight is slowing, and the non-cash economy is arguably shrinking. Part of the current turnaround reflects high oil prices, but it also results from the beginning of renewed investor confidence.

What directions will reform take? My guess is that it will include progress on five fronts: property rights/privatization, tax reform, increased competition, financial-sector rationalization, and reduced regulation and other government intrusions. Impediments to the emergence of the spirit of enterprise and innovation almost certainly will be reduced.

While the concept of private property is evolving in Russia, the notion of deeds of ownership and inviolate government registry of property rights is still not well developed. Corporations do not fully comply with rules and accounting standards that are on the American or German model. Minority shareholder protection is far from fully assured.

One thing nearly everyone agrees must happen is tax reform. The tax system is complex, rates often are excessively high, and tax compliance is a serious problem. The reformists seem to favor a system with a few broad-based taxes with relatively low marginal rates. In some areas of the country, taxes for business are effectively negotiated with the authorities, with payment in goods rather than cash, leading to huge problems of horizontal inequities, misallocation of resources, and corruption. The payroll tax is 41 percent, supposedly on all wage income, leading to large wage payments in non-cash forms. This is on top of individual tax rates that reach 30 percent at the margin, and a 20 percent value added tax. As one prominent diplomat said: "It is impossible to make a good living in this country without breaking the law."

Above all, Russia's government is just too large for a developing economy. Government expenditures in 1999 exceeded 35 percent of GDP, independent of the resource allocation effects of regulation. Many of the Russian officials agreed that economic growth would accelerate if government's share of output were significantly reduced.

There are still a large number of highly inefficient government monopolies, including gas and electric utilities and the railroads that use their political power to maintain counterproductive government subsidies. Complicating the problem is that it is illegal to cut off utility service to customers for nonpayment. The concept of "no payment, no service" clearly needs to be addressed.

The 1998 financial meltdown devastated financial institutions. While Russia has the largest central bank in the world in terms of resource usage, it has relatively little to regulate. A strong message needs to be sent to the international community as to the ultimate policy goals of the monetary authorities (e.g., the elimination of inflation, meeting foreign debt obligations). Restrictions on foreign banking are reducing competition that would be healthy for society.

Too many Soviet-style restrictions still exist. There are significant costs of registration associated with new business start-ups; particularly bad given the role that small business plays in the evolution of New Economy activities. There are still too many price controls, currency controls, export controls, regulation of product quality, etc.

Additionally, much local government revenue comes from Moscow, separating the raising of money from the spending of it. This reduces the accountability of local politicians and invites excessive spending and waste. American-style tax competition is possible, given the existence of 89 distinct regional governments.

• Prospects: There are many obstacles, political and economic, that Russia faces. Yet President-elect Putin is intelligent, seems committed to reform, and apparently is getting good advice from the reformers. Russia has a highly educated population and vast natural resources. The education factor makes it a potential long-term powerhouse in the New Economy. Historical experience suggests real output could double within a decade. The transitional decade from communism to capitalism is coming to a close and with that the prospects of economic growth widen. Especially helpful is that the attitudes of Russians under, say, 35 years of age, are much different than that of their parents. They are more willing to take risks, and assume personal responsibility in a world with scarce resources. With the right leadership, this generation can build a truly capitalist Russian society.

Russians have always tended to feel safer with the "strong man" national figure to lead them, for better or worse, to what they hope will be brighter days. It remains to be seen whether Vladimir Putin will have the political strength necessary in 21st century Russia to go the distance, and transform his country into a model of free enterprise.

Richard Vedder is an adjunct fellow of the Center for the Study of American Business at Washington University in St. Louis and teaches economics at Ohio University.

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