Hasty Resource Privatization Helped Putin Get Power
Unintended Consequences
Could the human suffering in Ukraine have been reduced or avoided? The origins of Putin’s rule lie, at least partially, in decisions made in the crucial years after the collapse of the USSR. One of the main problems, in the 1990s, was the hasty distribution of Russia’s immense natural resources at a huge undervalue. Much of that wealth ended up with people that we now know as Putin’s allies.
There were many potentially pivotal points in the path to war in Ukraine, not least the international politicking of the last two decades. In the twentieth century, Russia was also subjected – not once, but twice – to extreme economic experiments based on Western academic theories. The first was in 1917, based on Marxism. The second was in the 1990s, adopting ‘shock therapy’ to move rapidly to a market economy. Today, I look at the second.
‘Shock therapy’ is generally used to describe the rapid process of deregulation, price liberalisation and privatization that happened in the former Soviet states in the 1990s.
Disclaimer: the experts are not unanimous on this story. If you are not convinced that the hasty sale of Russia’s natural resources helped Mr Putin get where he is now, please treat this as simply a parable about unintended consequences. Or if you are resolutely convinced that reforms never have unintended consequences, then I'm afraid I can't help you.
The anonymous but respected Twitter economic historian @pseudoerasumus gives one simple (but, sadly, locked) account of where Yeltsin’s reforms in the 1990s went wrong.
Pseudoerasmus points out that the end of the Soviet Union meant the end of an integrated economic space within the USSR and COMECON. As a result, it was difficult or impossible to salvage most industrial enterprises that were not natural resources extraction-and-export operations. ‘All countries in Eastern Europe and the ex-USSR did shock therapy, with bad short-run consequences… there was simply no alternative to fiscal austerity, since revenue sources were disappearing in all these states’.
He argues that the problem was not removing price controls. Prices that had formerly been set by central planning had to a large extent already become effectively liberalised on the black market. So some form of shock therapy was inevitable: removing price controls was just recognizing the reality.
Branko Milanovic agrees that in early 1992 the Prime Minister of Russia, Yegor Gaidar, ‘had no option but to liberalize prices lest the county fall into famine – so horrendous were the conditions at the time.’
And speed of change was not necessarily the problem:
But ‘in the case of the post-Soviet states, privatization of natural resource monopolies deprived them of fiscal capacity with which to finance both rebuilding and social support.’1
Russia has fabulous natural wealth which generates a gushing flow of rents and foreign currency. The regime privatized those resources at a huge undervalue, sometimes for free. And that, Pseudoerasums argues, deprived the Russian state of the revenues with which to afford better economic decisions.
For example, the 1995 ‘loans for shares’ scheme, conceived by Vladimir Potanin of Oneximbank, disposed of Russia’s nickel and fossil fuel assets at bargain basement prices to banks controlled by oligarchs. Potanin picked up Norilsk Nickel, the world's number one smelter of palladium and nickel. And he, Mikhail Khodorkovsky, and Boris Beresovsky acquired Russian oil giants Sidanco, Yukos, and Sibneft.
In an alternate world with shock therapy but no natural resource privatization, says Pseudoerasmus, the Russian state would have had higher revenue and smaller deficits. That would have meant less monetisation of the debt (effectively, printing less money) and less inflation. That would have mitigated the 1998-99 crisis when the Russian state defaulted on its debts, if it happened at all. It would have given the government more resources with which to strengthen democracy, the rule of law and other institutions vital to a developed economy. And that would have made Mr Putin’s entrenchment of power less likely.
The problem was not just that the revenues from natural resources stopped going to the government. Billions of dollars’ worth of natural resource assets were transferred to kleptocrats who focused on political fights to extract more rents. That political rent-seeking reduced productive investment in the private sector and political stability in the public sector, rather than building up the institutions of the state to make the economy work better. Many of those rents now flow to people who have supported Mr Putin from the beginning. A former deputy prime minister, Boris Nemtsov, described the Russian system as ‘bandit capitalism’.
Of course, the giveaways were not just of natural resources. Stephen Kotkin's book notes that ‘the AvtoVAZ carmaker was purchased at a voucher auction for $45 million, whereas in 1991 Fiat had offered $2 billion – and been turned away.’ In contrast, Poland did not have comparable natural resources to sell off at an undervalue to a new class of oligarchs, and has done far better.
Markets don’t exist in a vacuum. It takes time to build up the institutions that guarantee property rights and the rule of law underpinning modern economies. Poland was motivated to adopt a range of EU institutions to qualify to join the EU. Russia, in contrast, lost some of the good institutions that it already had in negative-sum fights among oligarchs about natural resources.
To be clear, I am not saying that privatization is always bad, or good. I'm not saying that resources should never be partly or wholly privatized. Norway seems to have done the former well. Democracy is much more strongly entrenched in Norway than it was in 1990s Russia. Context, method and speed of reform matter.
But a policy can work in one place at one time and backfire drastically somewhere else. The other rules of the game and the identities of the players are critically important. We cannot just naively copy and paste reforms. Nor should we blithely impose change without trying to work out the potential consequences.
In a fascinating interview for the 80,000 hours podcast, institutional economist Mushtaq Khan illustrates questions to help work out why some reforms succeeded or failed. Which groups got more power and resources through the reforms? In Russia, a small group of oligarchs with incentives to weaken democracy. Did they get an incentive to improve productivity, or just to sit there and collect the rents? In Russia, it was clearly the latter. Was there contestability - scope for other more productive groups to come in? In Russia, it seems to have been very difficult.
Picking good reforms is hard, partly because there are so many options. One way to think about this is the curse of dimensionality: ‘if you select physical outcomes at random, most of them are horrific. Try randomly arranging the atoms of your body in the space you currently occupy – the overwhelming odds are that you’ll be dead. Good outcomes ... are almost vanishingly rare. The entire enterprise of life consists of machines fighting against entropy locally, selecting for the few good possibilities from the many fatal ones.’
Russia is one example of the risks of unintended consequences. There are plenty of others. Leopold Aschenbrenner argues for epistemic humility and in favour of mechanisms of error correction, experimentation, competition and adaptation.
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Large natural resource assets can cause political problems. They are an attractive target for people to seize them and run the state corruptly to maximize their own short term profits. Pseudoerasmus suggests that the Russian government should have retained control of its natural resource wealth, if it could, until its institutions were more robust against those sorts of risks. It might have been better to focus on getting the rules and structures of institutions correct instead of rushing out to privatize – although that may not have been a realistic option for Mr Yeltsin at the time.
But that is certainly not to say that positive policy change is impossible. Please sign up below if you would like to know more, and please share this with others who might be interested.
Pseudoerasmus, with my emphasis