A Chilean Model for Russia

FREE MARKETS, FREE PEOPLE

What Russia needed at the beginning of the twentieth century was not a Bolshevik Revolution but an American one. The tragedy of that great nation was that it got a Lenin instead of a Jefferson. Today, nearly ten years after the collapse of the Soviet Union, Russia's new president, Vladimir Putin, has the historic opportunity to start the freedom revolution that his country missed last century.

I had the opportunity to assess Russia's situation at the end of April, when I traveled to Moscow at the invitation of President Putin's newly appointed economic adviser, Andrei Illarionov. As a member of the team of economists that entered the Pinochet government in Chile in the 1970s to produce a free-market economic revolution and a return to democratic rule, I was inevitably asked whether Russia "needed a Pinochet" and whether the country should introduce a "Chilean economic model." My unequivocal answer was no to the first question and yes to the second.

President Putin and his government must not identify the core of the Chilean experience with its historically specific interruption of political liberties. Such a break has happened in many other nations, and in almost all cases, their generals-turned-presidents have not only been a disaster for their countries but have also left a legacy of more state intervention and corruption. I told my Russian audiences that the replicable aspect of the Chilean model is the radical, comprehensive, and sustained move toward free markets.

That model not only doubled Chile's historic rate of economic growth (to an average of 7 percent a year from 1984 to 1998) and reduced the proportion of people living in poverty from 45 percent in 1987 to 22.2 percent in 1998. It also unleashed the forces that brought liberal democracy and the rule of law. Those who argue that a nonelected legislature was necessary to accomplish those beneficial free-market reforms are not only factually wrong but also weaken the case for democracy by implying that correct public policies cannot be understood by the people and their elected representatives. Having helped "export" Chilean pension reform to ten very different countries, I can attest that the indispensable element common to these reforms was not a strong four-star general but a team of determined policymakers who knew that freedom works -- and that the people would understand that concept if it were well explained.

If President Putin is convinced, as he has said he is, that economic freedom is the road to high growth, he can find such a team in Russia to implement the reforms necessary for the transition to a modern free economy and to achieve an economic and political status consistent with the nation's cultural achievements. Indeed, with a GDP smaller than Spain's (a country of 39 million people), Russia is performing far below its potential. Both the president and his 146 million compatriots are painfully aware of this.

Russia is like a giant in chains. Aleksandr Solzhenitsyn expressed it best when he recently said, "The creative strengths of the people, which were repressed under the communists and still are today, could get everything moving. Millions of Russians are blocked by a wall of administrative and bureaucratic arbitrariness. They have no one to complain to, no court to protect their rights." Their enormous potential needs only to be unlocked.

RUSSIA FOUND

The 1998 fall of the ruble and the subsequent financial crisis prompted many to ask, "Who lost Russia?" Market reforms were often blamed for the country's turmoil. George Soros, for instance, recently claimed that "the economic reform efforts were dismal failures. ... It is exactly the market fundamentalist bias that must be held responsible for the outcome." But that diagnosis of the Russian crisis is wrong and ignores the progress that the country has made in significant areas.

True, according to official figures, Russia's economy has shrunk an average of 5.4 percent per year since 1991. But Russia does not have a market economy. In terms of economic freedom, Russia ranks 93rd out of 123 countries surveyed, between Zambia and Bangladesh, in the latest Economic Freedom of the World report. There is no rule of law; private landowner property rights are virtually nonexistent; many businesses receive government protection; key enterprises are still largely owned by the state; minority shareholder rights are regularly violated and corporate governance rules are extremely weak; the ruble is unstable; tax rates are confiscatory; government spending is high; and Moscow's bureaucracy is larger than it was even during Soviet times. The 1998 crisis was the predictable culmination of an inconsistent mix of market and interventionist policies, some or all of which were also present in the Latin American and Asian countries that experienced crises in the 1990s. Clearly, Russia's disappointing economic performance must be attributed mainly to the lack of a coherent process of market reforms, not strict adherence to free-market policies.

The country's difficulties are also, to an important extent, due to its 70 years of communism, a much longer and more pervasive totalitarian episode than that experienced by Eastern Europe. Despite the weight of Soviet history, the changes have been profound, and Russia today is a dramatically different country than it was in 1991. It has achieved a peaceful transition from a totalitarian state to a democracy, however imperfect -- an immensely difficult task in itself, for which former President Boris Yeltsin deserves more credit than he generally receives. Russia's important advances -- admittedly incomplete or flawed in execution -- also include widespread privatization, price liberalization, and the opening of the economy to investment and trade. (Critics of the reformers often forget the extraordinary challenge in taking charge of an economy when the budget deficit was approaching 30 percent of the GNP, as was the case in Russia at the end of 1991.) And of course, on May 7, 2000, Russia went through the first democratic transfer of power in its 1,100-year history.

Therefore, to ask who lost Russia is inappropriate. Russia is not lost; it has taken many years and a financial crisis to achieve the preconditions -- both political and economic -- for further reforms. The challenge for Putin now is to introduce such reforms in a country where much of the population has developed a cynical view of capitalism -- a perception resulting from the slow pace of change, the crash of the ruble, the reforms' flaws, and the consequent rise of the so-called oligarchs. Russians can be forgiven for that cynicism. They heard from many Russian and Western financial officials that their country was moving swiftly and successfully to the free market. But the reformers never did explain to the public the logic and implications of the policy changes, something essential for successful free-market reforms. In the minds of many Russians, the post-Soviet experience has only confirmed the Marxist textbook version of capitalism. A critical task for the Putin administration will be to communicate clearly and regularly with the Russian people about the purpose and importance of market reforms.

FOUR REFORMS FOR HIGH GROWTH

In the first quarter of 2000, Russia experienced an official growth rate of eight percent. But such rapid growth will be short-lived. After a yearlong recession, the country is merely experiencing a bounce-back effect produced by the devaluation of the ruble and helped by high oil prices. For Russia to grow at self-sustaining rates of seven to ten percent for one or two decades -- the only way that it can pull itself out of poverty and address its many problems -- it must significantly increase its economic freedom. Putin made a striking statement along those lines on a recent visit to the declining industrial city of Ivanovo: "The higher the degree of economic freedom of economic entities, the higher the level of the development of the state."

Russia can achieve high growth by implementing four top-priority reforms: pension privatization, tax reform, radical deregulation, and the replacement of the ruble with the euro. The guiding concept, applied rigorously in both Chile and New Zealand during those countries' reform periods, is to eliminate the system of state-sanctioned privileges, which prevails throughout the Russian economy. In addition, to be effective, the reforms must be carried out as part of a single initiative.

A NATION OF CAPITALISTS

Letting working Russians keep their own retirement savings instead of giving them to the government would be wildly popular in Russia, as I saw at a two-hour press conference attended by some 70 journalists at the Interfax News Agency and at a meeting headed by former Deputy Prime Minister Boris Nemtsov with leading legislators at the Duma (Russia's lower house of parliament). At the end of my day at the Duma, Nemtsov appeared on national television explaining to workers the benefits of holding their old-age savings in private property accounts. By the evening of the next day, my press conference had been broadcast on all the major national television stations; the following morning, it was covered in the country's newspapers.

Like those of all countries with pay-as-you-go social-security schemes, Russia's system is going broke and will have to be reformed sooner or later. Indeed, inflation has eaten away at the real value of pensioners' benefits over the years. The inadequate benefits are accompanied by social-security payroll taxes of 29 percent. This high rate raises the costs of labor and encourages unemployment, putting further pressure on the public pension program. Expenditures on social security already constitute much of the government's budget outlays. In short, the high costs and low benefits of the public pension system rob people of security in their old age and discourage overall economic growth. The longer the country postpones reform, the more difficult it will be to make the transition to a fully funded system.

The Russian government should follow the principles applied in Chile: workers should be allowed to place their retirement savings in their own accounts to be privately managed by competing firms, which would invest that money in capital markets over the working lifetimes of their clients. Giving ordinary Russians the choice of remaining in the state-run system or moving into the private system makes it more difficult for politicians to obstruct reform. (When workers were given that choice in Chile in 1981, 25 percent chose the new system within the first month alone; now 94 percent are in the private system.) New entrants to the labor force, however, should go directly into the private pension system. That will permit Russia eventually to close the door on the state-run system that politicians -- as has been the case in all countries -- have abused for political purposes, and it will protect the private system from being undermined by a publicly managed, unfunded system. Finally, the benefits of current retirees and of those people remaining in the old system should not be altered. Such a measure is both fair and politically prudent since it, too, removes potential opposition to privatization.

Russian pension reform needs to be fitted to Russian conditions. Unfortunately, because of the 1998 crisis, the most salient feature of Russia's economic situation is a justifiable lack of trust in the nation's financial sector, which essentially no longer functions. A functioning banking sector and capital market, moreover, are hindered by the presence of a large barter economy and a lack of transparency in business transactions. Thus the primary feature of the first stage of Russian pension reform should be a strong emphasis on investments abroad in competing global index funds. Under current conditions, that would be the only way to safeguard workers' savings. Workers should also be given the choice of investing their savings in Russia, thus helping to create -- with prudent gradualism -- a domestic capital market.

Gaining the most from pension privatization would not only require other reforms; it would drive them. A reform that allows Russians to invest their pension savings abroad sends a powerful signal about the openness of the country's economy and about the Russian government's view that capital will be permitted to flow both ways, something that would itself encourage greater foreign investment in Russia. But the most important impact of pension reform is the paradigm shift it produces by creating a country of property-owning workers who favor free-market economic policies. Put simply, the rise of worker capitalism would turn Marx on his head. Done properly and accompanied by other reforms, pension reform can stimulate a virtuous cycle in which workers invest their savings in capital markets, and markets increasingly invest in Russia as both the financial and the corporate sectors develop.

Since the Republican presidential candidate, George W. Bush, has recently announced his desire to reform Social Security by introducing private retirement accounts, a new "pension reform race" between the United States and Russia -- a more benign kind of race than in the past -- has broken out. And in this race, Russia has a chance of "beating" the United States.

NO EXCEPTIONS

Throughout Moscow appear posters of the city's founder, Yuri Dolgoruky (whose nickname was the "Long-Armed" for his accumulation of land and property), extending his hand with a caption urging Russians to pay their taxes. But Russians are paying him no heed. Russian taxes are complex, high, full of exceptions, and uncollectible. Total payroll taxes reach about 39 percent, while the marginal income-tax rate for those of modest earnings is about 20 percent. In the 1999 tax year, only 3.8 million Russians filed income-tax declarations. Compliance with all the tax laws would result in an effective average tax rate of about 50 percent. Boris Federov, a former finance minister and chief tax official, explains that there is no logic or theory to the nation's tax code. The high and multiple rates discourage growth and encourage the spread of the barter economy and the informal sector, estimated to be at least 25 percent of GDP.

Russia needs a radical overhaul of its tax policy. The payroll tax could be cut in half without affecting revenues significantly. The personal income tax, which provides only 3.9 percent of the state's revenues, should be eliminated entirely. In place of those taxes, Russia should maintain only its value-added tax and apply it at a flat rate with no exceptions whatsoever. Those measures will encourage job creation, investment, and a more transparent business sector as firms find compliance more reasonable than cheating. With more firms operating in the open as a result of the reduced tax burden, foreign and domestic banks will be better able to extend credit based on reliable assessments of firms' financial conditions. The simplicity of the flat value-added tax structure would go a long way toward ending the discriminatory treatment that many productive firms face, making it more difficult and less necessary for politically powerful but inefficient industries to negotiate special tax arrangements with the authorities. Those reforms should be accompanied by focusing government spending strictly and more efficiently on the poor and vulnerable, thus creating an effective safety net. In short, Moscow must move away from its "long-arm" tactics of tax collection and toward a simple but modern approach consistent with high growth.

SMASHING THE MONOPOLIES

The Russian economy is still dominated by state-sanctioned monopolies in energy and uncompetitive industries that receive various forms of state protection. According to Yevgeni Yassin of the Higher School of Economics, some 40 percent of all Russian businesses actually lose money. Largely because the gas and electricity monopolies are forced by the government to provide low-cost services to unproductive firms, many such firms stay in business, undermining more-productive companies that do not enjoy the same support. Local governments, which have created local monopolies out of power stations and networks, have protected their industrial sector by providing this sort of subsidy.

Combined with high tax rates, the implicit subsidies create a lack of transparency in accounting practices and entail high social costs. In addition to sustaining an inefficient arrangement in which businesses largely pay each other and the government in kind rather than in cash, the Russian system breeds corruption and uneven enforcement of tax laws, since most large firms negotiate their dues to the state.

Widespread deregulation, including free entry by Russian and foreign firms into all segments of the energy sector, would help create the competitive conditions that Russia lacks. Greater competition among firms would change not only the "hard" infrastructure of the economy but also its "soft" infrastructure -- accounting standards, legal practices, and even cultural attitudes. Were those changes to come about, of course, the financial system could operate properly by channeling savings to productive investments. Allowing firms to go bankrupt and generating incentives for competition -- through, for one thing, more-transparent and less-costly transactions -- is necessary to achieve a more efficient allocation of resources.

GOOD RIDDANCE TO BAD RUBLE

Neither Russia's financial system nor its business sector will develop to its full potential unless fundamental monetary reform is introduced. The record of the Russian central bank has been disastrous: periods of high inflation, a 75 percent devaluation of the ruble since 1998, and the collapse of the country's financial system after the central bank spent $10 billion in a failed attempt to prop up the ruble in 1998. In the 1990s, the central bank confiscated the wealth of Russians in five separate episodes of inflationary bouts, defaults, or currency control. Former Acting Prime Minister Yegor Gaidar provides an insightful explanation of that sorry record:

The most important impetus for currency emission was the state's inability to conduct its business in such a way that expenditures were always covered by revenues and market borrowings. ... This is the simplest and most effective of all existing taxes. ... No tax police are needed to collect it ... but it is also terribly destructive for the economy. Sooner or later it is bound to throw the nation's currency -- that most important component in a delicate market mechanism -- into turmoil.

Russians are understandably distrustful of the ruble and sensitive to the tremendous uncertainty created by their central bank. Already, citizens seem to have chosen to use the dollar and other foreign currencies, rather than the ruble, whenever they can.

Why not take the next logical step? For the reforms to work better, Russia should officially replace the ruble with the euro. The choice of the euro rather than the dollar makes sense, given that Russia more closely identifies with Europe than with the United States and given its closer trade ties to the continent. Better yet, the euro is not associated with any single country -- most importantly not Russia's superpower rival -- but is the currency of a collection of countries.

By itself, that relatively simple measure would provide a tremendous boost to the economy. In one stroke, Russia would adopt a serious currency, reduce interest rates, and give millions of foreign and domestic investors security in their business transactions. The move would also give people the ability to make financial plans for the future and would stimulate the creation of long-term credit markets, including mortgages, which are virtually nonexistent today.

Adopting the euro should not imply joining the European Union or adhering to EU policy standards, even though a free-trade treaty would be consistent with the larger goal of anchoring Russia in Europe (as was the case with Germany after World War II). Problems of lost seigniorage (the profit a country makes from printing its own currency) can be easily dealt with; indeed, the U.S. Congress is already considering a bill to reimburse "dollarizing" countries for reductions in seigniorage. The EU could adopt a similar measure. The lender-of-last-resort function currently performed by the central bank would not disappear; it would merely be taken over by private-sector lenders of last resort who would certainly be more effective at monitoring financial institutions than the Russian central bank has been. Finally, the increase in security and growth produced by the use of the euro would give the economy a greater ability to weather outside shocks, which in any event would be smaller than those produced by the central bank.

Use of the euro, a liberalized banking sector integrated into the international financial system, and greater domestic competition will finally enable Russians to use the world's and their own savings for productive purposes.

IT CAN BE DONE

Russia's task is awesome and daunting, but it is possible. In Chile we also faced seemingly insurmountable barriers to what turned out to be a breakthrough for the country. But from the beginning of the reform period, the objective was the transformation of a society based on state interventionism to one based on individual liberty and free markets. The obstacles to such radical reform can be overcome in countries in turbulent transition. Structural reform is actually much harder in more rigid societies such as those of continental Europe (where the "transition" to a fully common economic area may be the opportunity and catalyst for much-needed radical change in such overregulated areas as labor and social welfare).

Even though prevailing world economic policies and the ideology of the 1970s did not favor free-market ideas, Chile had a team of economists, trained at the University of Chicago and other top U.S. universities, who agreed on the need to end the country's state-dominated development approach and, even before entering government, began an educational and communications effort to spread their ideas around the country. Today, there is an international consensus on free-market policies, and Russia can introduce reform and benefit from an increasingly liberal world economy in a way that Chile initially could not.

The main obstacle to reform that Chile faced -- and that Russia now faces -- was the opposition from special interests whose privileges would end under the proposed new policies. Thus business leaders opposed free trade, and unions opposed a more flexible labor market. Overcoming those obstacles required a coherent economic program and direct appeals to the people. By clearly communicating the purposes, costs, and benefits of the reforms -- and by emphasizing that the reforms aimed to eliminate state-sanctioned privileges not for one group but for all equally -- the government rested its credibility on achieving those goals in a fair and independent way. This, in turn, made it more difficult for special interests to impose their preferences. Once the heretofore opaque process of policymaking is exposed to the daylight clarity of media and debate, it becomes obscene for entrenched interests to demand monopolies, protection, and subsidies from the state.

Although the path Putin will take is still unclear, I am cautiously optimistic about the prospects for reform. Putin was elected with more than 50 percent of the vote; he remains popular and has the political support of much of the Duma. He has appointed some experienced free-market economists as advisers and appears aware of the need for economic freedom and high growth. Information-age technological advances continue to expose Russian society to new ideas, products, and innovations, making central control of the economy increasingly difficult. And the country will benefit from its immense resource wealth and well-educated population once the proper policies and institutions are in place. Those, of course, include the rule of law, freedom of expression, and the protection of other civil liberties.

In drawing lessons from Chile, the Putin administration must follow the basic thrust of the Chilean model, which was to devolve power to society rather than to centralize it. That unique and perhaps unexpected approach also distinguished Chile as an economic success story on a continent suffering through the "lost decade" of the 1980s. And as in present-day Mexico, economic liberalization also led to political liberalization. Moreover, the reduction of privileges, the transformation of every worker into an owner of financial capital, and the rise of economic opportunities created a wide middle-class constituency that has defended the country's free-market model under various popularly elected center-left administrations.

Change in Russia is only a matter of time. As Richard Pipes of Harvard observed a few years ago, Russians under thirty react very differently to the new conditions than their frightened and bewildered elders. They like the changes: they are quickly learning to swim in the turbulent waters of a free economy and looking confidently to the future that will assure them of financial independence. They display the sense of competence and self-assurance that possession and, it seems, even the anticipation of possession have been observed to bring about. And they are the Russia of tomorrow; for as Coleridge once wrote, there is "but one infallible source of political prophecy," and that is the knowledge of the principles and opinions that guide men between the ages of twenty and thirty. If this is true, there are grounds for believing that when the inevitable time comes for Russia's young to take charge, a different and much better Russia will emerge.

The future will weigh more heavily than the past. Putin can begin creating that future by removing artificial obstacles to high growth and thereby drawing on the energies of all Russians. If he moves in that direction, he will do nothing less than spark a revolution. If he does not, Russia will have to wait for the new generation to take over.