A Chilean model for Russia

By José Piñera
[Foreign Affairs, September/October 2000]

(In Russian)

"In the end, more than they wanted freedom, they wanted security. They wanted a comfortable life, and they lost it all—security, comfort, and freedom. When the Athenians finally wanted not to give to society, but for society to give to them, when the freedom they wished for most was freedom from responsibility, then Athens ceased to be free."

—Edward Gibbon, The Decline and Fall of the Roman Empire

Russia in many ways suffers from the Athenian affliction described by Gibbon. Russians never had real freedom under centuries of czarist rule, and communism’s false promises of comfort and security eliminated what freedoms they had. Today, nearly 10 years after the collapse of the Soviet Union and under the leadership of newly inau­gurated President Vladimir Putin, Russia has the opportunity to initiate a revolution based on liberty.

I had the opportunity to assess Russia’s situation when I traveled to Moscow at the invitation of President Putin’s newly appointed economic adviser, Andrei Illarionov.[1] My impression, after a weeklong visit at the end of April, is that Putin can, if he wishes, implement the reforms necessary for his country to make the transition to a modern economy and achieve an economic status that is consistent with the nation’s cultural achievements. Indeed, Russia, with a gross domestic product smaller than that of Spain (a country of 39 million people), is far below its potential.[2] Both the president and his compatriots are painfully aware of this.

In a speech I delivered at the Presidential Administration, formerly the head­quarters of the Central Committee of the Communist Party, I compared Russia to a giant in chains, whose enormous potential needs only to be unlocked. Alexander 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.”[3]

What follows is a brief assessment of why I think Russia is not a lost cause and a summary of the recommendations I made during numerous working meetings with leading members of Moscow’s policy community.

Is Russia Lost?

The 1998 fall of the ruble and subsequent financial crisis prompted many to ask, “Who lost Russia?” and to blame market reforms for the country’s turmoil. George Soros recently claimed, for instance, that “the economic reform efforts were dismal failures. . . . It is exactly the market fundamentalist bias that must be held responsible for the outcome.”[4] But that diagnosis of the Russian crisis is wrong and ignores the progress that the country has made in significant areas.

It is true that, according to official figures, Russia’s economy has shrunk an average of 5.4 percent per year since 1991.[5] But Russia does not, of course, have a market economy. Suffice it to say that, in terms of economic freedom, Russia ranks 93rd, between Zambia and Bangladesh, of 123 countries in the world, according to the latest Economic Freedom of the World report. There is no rule of law; private property rights in land are virtually nonexistent; many businesses receive state protection; key enterprises are still largely owned by the state; 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 present in the Latin American and East Asian countries that experienced crises in the 1990s.[6] Clearly, Russia’s disappointing economic performance can be attributed mainly to the lack of a coherent process of market reforms, rather than to adherence to free-market policies.

Another factor that cannot be ignored is that the country’s post-Soviet difficulties are to an important extent due to its 70 years of communism, a much longer and more pervasive totalitarian episode than East European nations experienced. Very few observers understood that the communist system of the Soviet Union, in its inherent opposition to human nature, was doomed to fail. As Cato Institute president Edward Crane presciently noted in 1982 after his first visit to the Soviet Union:

The U.S.S.R. is a society that appears to be crumbling from within. If we can avoid confrontation with the Soviets over the next twenty years, their system should collapse of its own bureaucratic weight. . . . If the cracks that are appearing in the Eastern block nations reach the U.S.S.R., they will spread rapidly throughout the country.[7]

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 not only achieved a peaceful transition from a totalitarian state to a democracy, however imperfect—an immensely difficult task in itself for which Boris Yeltsin deserves more credit than he generally receives. Russia’s important advances, however incomplete or flawed in their execution, also include widespread privatization, price liberalization, and the opening of the economy to investment and trade.[8] (Critics of the reformers often forget the extraor­dinary challenge entailed in taking charge of an economy when the budget deficit was approaching 30 percent of the gross national product, as was indeed the case in Russia at the end of 1991.) The changes are visible. One emblematic example is the disappearance of queues, a distinctive sign of socialism (one could almost formulate the following hypothesis: where the state is present, there are queues). And, of course, on May 7, 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 along the way to achieve the preconditions—political and economic—for further reforms. The challenge for Putin is to introduce 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, reform flaws, and the consequent rise of the so-called Russian oligarchs.[9] Russians can be forgiven for that misperception. 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 that in my view is essential for successful free-market reforms. In the minds of many Russians, the post-Soviet experience has validated the textbook version of capi­talism that Marxism taught. Thus, 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 8 percent. But it 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 7 to 10 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 level of economic freedom. Putin made a remarkable 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.”[10]

I believe that Russia can achieve high growth by implementing four 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 that prevails throughout the Russian economy. In addition, the reforms must be carried out as part of the same initiative to be effective.[11]

Pension Privatization—A Nation of Capitalists

The idea of letting working Russians keep their own retirement savings instead of giving it to the government would be wildly popular in Russia. I was able to test the appeal of that idea on a couple of occasions during my visit to Moscow: 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 the day of my meeting at the Duma, Nemtsov appeared on national TV 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 was broadcast on all major national TV stations, and it was covered the following morning in the country’s newspapers.[12]

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. The longer the country postpones the reform, the more difficult it will be to make the transition to a fully funded system.[13]

The Russian government should follow the universal principles applied in the Chilean privatization: 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 also makes it more difficult for politicians to obstruct reform. (In Chile, when workers were given that choice in 1981, 25 percent chose the new system within the first month; now 94 percent are in the private system.) New entrants to the labor force, however, should go into the private pension system. That will permit Russia to eventually 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.

But Russian pension reform should 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, for all intents and purposes, 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 Russian pension reform should be a strong emphasis in the first stage of the reform 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.[14]

Gaining the most from pension privatization would not only require other reforms; it would impel them. A reform that allows Russians to invest their pensions 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 form a constituency that favors 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 American 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!

Taxes—No Income Tax, A Flat Value-Added Tax

Throughout Moscow appear posters of the city’s founder, Yury Dolgorukiy (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. Yet Russians are paying no heed. 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. For the 1999 tax year, only 3.8 million Russians filed income tax declarations.[15] Compliance with all the tax laws would result in an effective average tax rate of about 50 percent. As Boris Federov, former finance minister and chief tax official, explained to me, 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 reduced by about half without affecting revenues significantly.[16] 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. With more firms operating in the open as a result of the reduced tax burden, foreign and do­mestic banks would be better able to extend credit based on more 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 since it would make 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 a policy of focusing government spending strictly on the poor and vulnerable members of society in a more efficient way, 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.

Deregulation—The Best Policy for Growth and against Corruption

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 businesses are actually losing money. Largely because the national gas and electricity monopolies are forced by the government to provide services at low cost to unproductive firms, many stay in business and undermine 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.[17]

Combined with high tax rates, the implicit subsidies create a lack of transparency in accounting practices and produce high costs to society. 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 as 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. Allowing firms to go bankrupt and generating incentives for competition, through, for one thing, more transparent and less costly transactions, are necessary to achieve a more efficient allocation of resources.[18]

Stabilizing Russian Currency—Replacing the Ruble with the Euro

Neither the financial system nor the business sector will develop to Russia’s full potential unless fundamental monetary reform is introduced. Indeed, the record of the Russian Central Bank has been disastrous with periods of high inflation, a 75 percent devaluation of the ruble since 1998, and the collapse of the country’s financial system (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.”[19]

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, as stores of value whenever they can.

Why not take the next logical step? For the reforms to accomplish their potential, 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. Another advantage is that the euro is not associated with any single country—particularly 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 provide 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 a logical step. Problems of lost seigniorage (the profit a country makes from printing its own currency) can be easily dealt with; indeed, there is already a bill in the U.S. Congress to reimburse dollarizing countries for reductions in seigniorage. The EU could adopt a similar measure.[20] 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 has been the Russian Central Bank. 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 the central bank has produced.

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 not impossible. In Chile we also faced seemingly impossible barriers to what turned out to be a “breakthrough” for the country. But, from the beginning of the reform period in the 1970s, despite no precedents anywhere in the world, we knew that we could accomplish a wholesale transformation of a society based on state interventionism to one based on individual liberty and free markets. My experiences in Chile and in diverse countries around the world lead me to the realistic belief that the obstacles to radical reform in a society in turbulent transition can be overcome, in contrast to the difficulties of structural reform in entrenched, corporativist societies such as those of continental Europe.

As a non-U.S. citizen, I felt no constraints repeating in front of various Moscow audiences that what Russia needed at the beginning of the 20th century was not the Bolshevik Revolution but the American Revolution. The country needed a Russian Thomas Jefferson and definitely not a Vladimir Lenin.[21] Vladimir Putin has the historic opportunity to lead the freedom revolution that his country missed in the last century. For that, he will need a coherent team to work together in actually carrying out policies. A competent team of economists and policymakers working on the same page was one of the critical features of the success of Chile’s reforms.

Though the path Putin will take is still unclear, I am cautiously optimistic about the prospects for reform. Putin is a president 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 a number of the country’s top free-market economists as advisers and appears aware of the need for economic freedom and high growth. Technological advances in the information age continue to expose Russian society to new ideas, products, and inno­vations, making control of the economy increasingly difficult. And the country can benefit from its immense resource wealth and well-educated population once the proper policies and institutions are in place.[22] Those, of course, include the rule of law, freedom of expression, and the protection of other civil liberties.

After my meetings with younger Russians, including a lecture to students at the Finance Academy of the Russian Government, I believe that change is only a matter of time. As Professor 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.[23]

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 be doing nothing less than sparking a revolution. If he does not, Russia will have to wait for the new generation to take over.

(José Piñera is president of the International Center for Pension Reform and co-chairman of the Cato Institute Project on Social Security Choice. As Minister of Labor and Social Security of Chile from 1978 to 1980, he was responsible for the creation of the system of individual retirement accounts (also called "capitalization system"). He thanks Ian Vásquez, director of the Cato Project on Global Economic Liberty, for his help in preparing this report and for joining him in Moscow).

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