Russia and Soviet Union

Tsarist Russian Transition to Socialism (1917) and Soviet Socialist Transition to Capitalist Russia (1991)

Russian Federation: Introduction

Russia has undergone significant changes since the collapse of the Soviet Union: (i) moving from a globally-isolated, centrally-planned economy to a more market-based and globally-integrated economy. (ii) Economic reforms in the 1990s privatized most industry, with notable exceptions in the energy and defense-related sectors. The protection of property rights is still weak and the private sector remains subject to heavy state interference . (iii) In 2011, Russia became the world's leading oil producer, surpassing Saudi Arabia; Russia is the second-largest producer of natural gas; Russia holds the world's largest natural gas reserves, the second-largest coal reserves, and the eighth-largest crude oil reserves. Russia is the third-largest exporter of both steel and primary aluminum. (iv) Other less competitive heavy industries remain dependent on the Russian domestic market. (v) Russia's reliance on commodity exports makes it vulnerable to boom and bust cycles that follow the highly volatile swings in global commodity prices. (vi) The government since 2007 has embarked on an ambitious program to reduce this dependency and build up the country's high technology sectors, but with few results so far. (vii) The economy had averaged 7% growth in the decade following the 1998 Russian financial crisis, resulting in a doubling of real disposable incomes and the emergence of a middle class. (viii) The Russian economy, however, was one of the hardest hit by the 2008-09 global economic crisis as oil prices plummeted and the foreign credits that Russian banks and firms relied on dried up. According to the World Bank the government's anti-crisis package in 200809 amounted to roughly 6.7% of GDP. (ix) The Central Bank of Russia spent one-third of its $600 billion international reserves, the world's third largest, in late 2008 to slow the devaluation of the ruble. (x) The government also devoted $200 billion in a rescue plan to increase liquidity in the banking sector and aid Russian firms unable to roll over large foreign debts coming due. (xi) The economic decline bottomed out in mid-2009 and the economy began to grow in the third quarter of 2009. However, a severe drought and fires in central Russia reduced agricultural output, prompting a ban on grain exports for part of the year, and slowed growth in other sectors such as manufacturing and retail trade. (xii) High oil prices buoyed Russian growth in 2011 and helped Russia reduce the budget deficit inherited from the lean years of 2008-09. (xiii) Russia has reduced unemployment since 2009 and has made progress on reducing inflation since 2010. (xiv) Russia's long-term challenges include a shrinking workforce, a high level of corruption, difficulty in accessing capital for smaller, non-energy companies, and poor infrastructure in need of large investments.

Russian Federation: Facts

GDP purchasing power parity: $2.414 trillion (2011 est.) GDP official exchange rate: $1.85 trillion (2011 est.) GDP real growth rate: 4.3% (2011 est.) GDP per capita: $17,000 (2011 est.), Labor Force: 75.41 million (2011 est. Unemployment rate: 6.6% (2011 est.) Population below poverty line 13.1% (2010), Distribution of family income- Gini Index: 42 (2010) Inflation rate: 8.4% (2011 est.), Current Account Balance: $101.3 billion (2011 est.)

The Rise of Bolsheviks/Socialism

(i) Vladimir Lenin leader of the Russian Social Democratic Party (Bolsheviks) since 1902 (ii) 1905 thousands of worker protesters fired upon, protesting hardships caused by war with Japan, Tsar forced to grant concessions , including formation of parliament (Duma). (iii) WWI, 14 million soldiers enlisted, 2 million killed, food production declined 30%, also corruption in Government , food riots in St. Petersburg (iv) 1917 February Tsar abdicated . Duma established moderate government headed by Kerensky of labor party. (iv) In October 1917 Bolshevik under Lenins leadership overthrew the provisional government and dedicated itself to establish socialism and ultimately communism. (v) Efforts to establish domestic control and reform complicated by Russian cooperation with the allies in WWI. (vi) White Russian party supported by foreigners occupied Urals and Siberia, Caucasus, Germans in possession of Ukraine, Baltic states declared independence, 75% of Russian land under opposition control. (vii) Lenin and his friends decided to cut losses by negotiating a separate peace with the Germans (1918). In exchange were required to recognize German control over several territories (Georgia, Ukraine, Poland and Baltic states) (viii) The truce with Germany precipitated an invasion of allied soldiers whose mission was to drag Russia back into war , to recover ammunition stored there and to protect investments that had been nationalized by the Bolsheviks.

War Communism (1918-1921)

(i) Bolsheviks printed money to fight all these wars, result: hyperinflation (ii) Decided to undertake radical measures (iii) Land decree: Confiscating all private and church land and Livestock without compensation. (iv) Military style of economic organization known as war communism (v) Police and /communist party activists sent to the countryside to extract surpluses from peasants forcefully (iv) Labor made compulsory (v) a strict system of military discipline exercised over labor. (vi) labor armies formed to rebuild roads , railways, to speed recovery of coal, mining, forestry, and oil extraction (vii) Equal wages paid to all in an industry. (viii) Food and other goods rationed to workers and families (ix) Foreign debt repudiated (x) Money abolished (xi) Private trade outlawed. (xii) 37000 enterprises nationalized. (xiii) workers movements restricted, deserters punished (xiv) By the end of 1920 Bolsheviks won wars against all, consolidated power and regained territories (xii) farmers, industrial workers and army against continuing WC (viii) WC abolished.

The New Economic Policy (1921-28)

(i)Combination of capitalism and socialism/ an experiment in market socialism (ii) Lenin said it was a temporary step backward to capitalism designed to get the economy back on its feet, so that it would become possible to take 2 steps forward towards full communism (iii) Land given to peasants so agriculture in Private hands (iv) Peasants could sell to coops, Nepmen (private traders), and government (v) Private trade legalized (vi) No rationing and acquisition of surpluses (vii) All industry except commanding heights denationalized (viii) Commanding heights industries (fuel, metallurgy, transportation, banking, communication, war industry, foreign trade) (ix) By controlling commanding heights industries Lenin believed that it would be possible to set the course for the rest of the economy (x) Industries allowed to establish trusts/cartels.(xi) Restrictions on labor mobility abolished (xi) Income equality gave way to market determined wages (xii) Labor legislation 1922 entitled workers to an 8 hour day and two week paid holiday (viii) social insurance benefits and collective bargaining rights (xiii) Money reintroduced (Chervonetz) and made stable (ix) Foreign trade revived, increased at 8% per year (x) Foreign concessions granted/investment encouraged. (xi) Lenin died 1925, but NEP continued.

Why NEP Replaced?

(i)For many CPSU workers NEP an unnecessary and unwelcome compromise with class enemies (ii) Growing strength of NEPMEN and Kulaks (rich peasants) perceived a threat by CPSU (iii) Agriculture recovered more rapidly than industry, agricultural production up, prices and farmer incomes declined (iv) Monopoly trusts increased industrial prices (v) Peasant terms of trade deteriorated (vi) Soviet authorities failed to understand working of a market economy (vi) Low prices of agricultural commodities paid by the government, so inevitable that peasants sell to NEPMEN (vii) Inflation: so peasants withheld in expectation of future price increases (viii) Inflation misunderstood, between 1924-27 MS increased 2665%, government used price controls to bring inflation under control. (ix) Failed to appreciate basic concept of opportunity cost (state grain procurement price less than peasant OC) (ix) State interested in amount of grain delivered to state than total grain production (x) Government intervention failed. Control on industrial prices and import of cheap foreign industrial goods resulted in profits for Nepmen (xi) 1.6 million UE rural areas (xii) General mistrust of the market system (xiii) National security, imperialist conspiracies. British broke diplomatic relations in 1927, Japanese activities in the Far East (xiv) CPSU realized that SU must become industrially , economically and militarily strong. To achieve this goal agricultural surpluses a must, something not possible under NEP small scale peasant agriculture. To establish large farms/collectives peasant agriculture must be replaced by large efficient collective farms (Kolkhoz).

Administrative Command Economy (1928-1991)

Decade of 1928 one of the momentous eras of recent history. Not only did Stalin implement fundamental and far reaching organizational and policy changes, he did so with tragic brutality. Fundamentally altering the nature of the Soviet economy in a short span of years. Both the mechanism and results of resource allocation changed fundamentally creating an entirely different economic system. The Three Pillars of the Administrative Command Economy: (1) The Transition of Soviet Economy: Nationalization: Changes after 1928 required new role for State especially in nationalization. New property rights needed to facilitate state control over means of production. State would be direct claimant to the output of economy. State needed new role in dictating resources allocation. By mid to late 30s nationalization virtually complete in all sectors. (2) The Transition of Soviet Economy: National Economic Planning: Planning is process for directing economic activity through appropriate organizational arrangements, based upon a plan designed to achieve specified objectives subject to constraints. Two types of planning: (i) Geneticists: Economic planning g should be dictated by consumer demand. The planners decide about direction of economic activity based on consumer demand. (ii) Teleologists: Social engineers formulate plan to dictate the direction of the economic activity. This type adopted in Soviet Union.

Soviet Central Planning

Basic Principles/ Functions of Soviet Planning: (i) Gosplan central coordinating body (ii) Other planning bodies (ministry, Republican) to submit their proposals to the Gosplan (iii) Control figures to provide general direction of the economy (iv) Actual detailed operation plans for enterprises to conform to control figures (v) Materials to be allocated through the system of balances which would elaborate the sources and uses of basic industrial materials (vi) Long term planning horizon five years (vii) The ministries - operational inks between Gosplan and the enterprises as they were involved in the planning process and in making actual distribution of industrial materials (viii) Gosplan made the national economic plan, it was the responsibility of the ministries to execute it. Planning Procedure: (i) CPSU establishes its priorities/output targets for next year (ii) Output targets disseminated through ministries (iii) Gosplan prepares control figures(preliminary estimates) (iv) Ministries and Gosplan together estimate input requirements (v) Ministries disseminate control figures to enterprises after disaggregating (vi) through planning hierarchy information begins to flow up from enterprise to Ministry to Gosplan. Figures aggregated. (vii) (continued on next slide).

Soviet Collectivization
(vii) Consistency of figures checked. Equilibrium reached when planned supplies of each commodity = material input requirements + final uses (viii) After balance achieved a final version of the plan presented to politburo for approval(ix) Approved, (techpromfinplan established) (x) Plan establishes enterprise output targets , input allocations, supply plans, delivery plans, financial flows, wage bills etc. (3) The Transition of Soviet Economy: Collectivization. (i)Collectivization was the forcible establishment of collective farms (The Kolkhoz) in the Soviet countryside. (ii) Party sent 25,000 police, industrial workers / party loyalists to oversee the process of collectivization in the countryside.. (iii) The militia and the secret police sent to the countryside to force the farmers into collective farms. (iv) Millions fled, deported, imprisoned and executed. Arrests provided initial manpower for penal labor. (vi) One estimate: 3.5 m in gulag penal labor force colonies, 3.5 m deported and resettled, and 3.5 m. died. (vii) 1933 communist party departments established in the machine tractor stations (MTS). The purpose of MTS was to supply machinery and equipment to the collective farms in return for payments in kind. The stations would play a significant role in the management of collective farms , along with the collective farm heads who were selected from ranks of reliable party members. (viii) Collectivization had political goals ( a means to control the rural population) and economic goals ( a mechanism to extract surpluses/savings from the rural population on terms dictated by the state). Both economic and Political goals of Stalin were achieved.

Soviet Economic Performance

1. Performance Comparison:(i) The performance of an economic system cannot be judged in absolutes. It can be judged only in relative terms. (ii) The Soviet ACE must be evaluated relative to its alternative, the market economy. (iii) Also when we compare two systems we should not compare the model of one economic system with the reality of a different system. (iv) Inappropriate to examine the weaknesses of planned socialist system judged against the ideal of a perfectly competitive market economy. 2. The market economies have a number of weaknesses (i) Potential monopoly problems (rent seeking) (ii) information (advertisement ) (iii) Macroeconomic instability (unemployment, inflation) 3. Centrally Planned Economies: Characteristics: (i) Property rights predominantly held by the state (ii) Information mechanism for decision making through planning mechanism (iii) decision making is centralized (iv) Incentives are mixed with substantial reliance on moral as well as material incentives. 4. Why system Good From Socialist Point of View: (i) State Property owner, so has control over how resources are used (state decides whether and how much of producer goods and consumer goods are produced, what proportion of nations income saved, what or consumed. So the fundamental issue of growth is influenced directly by the state and its agents (ii) Planner preferences supplant consumer preferences. (iii) Use of plan to direct resource use avoids anarchy of the market (UE, inflation) (iv) Center has an all encompassing vision of the economy, so central decision making is better (v) Socialism envisions a much more egalitarian distribution of income as state determines wages to the labor.

Critique of Socialism
1. Information Handling: Modern economy produces millions of distinct goods, , consists of millions of HH and millions of enterprises. The information problem facing CPB will exceed its capacity to handle information. 2. Soviet wholesale and retail prices did not send out reliable signals. Retail prices determined by demand , Wholesale prices determined by costs of production (mainly labor costs). 3. ACE lack Input Combination/allocative efficiency: MPL/Pl=MPK/PK. Ace also lack Technical efficiency: MC=MR. 4. Principal-Agents problems: Agents (enterprise Managers ) had superior information about local conditions than the Gosplan or the Ministries (principals) located thousands of miles away. The managers would use that superior information in a way that fulfilled their own interests rather than the interests of the economy/ministry/Gosplan. 5. Managers had a built in incentive to report false information to their superiors and Conceal capacity: The managers conceal or understate capacity in order to be able to easily fulfill output targets. 6. The Ratchet Effect: The managers will not produce more even if they could, because producing more this year means that next years output targets required to be fulfilled by Gosplan will be ratcheted up. 7. Socialism and economic growth: low time preference rates: The state controls investment thus allocating resources to those sectors that will contribute most to economic growth. 8. Socialism as a Perpetual Shortage economy: The managers over-demand inputs, because that will make it easier for them to fulfill output targets In ACE managers wanted more cement, steel, gasoline, and plastic than were available. Consumers wanted more TV sets , VCRs, meat and so on. Everyone wanted more than was available. .

Critique of Socialism
9. ACE and Soft Budget Constraints : Some economists say the most fundamental source of shortages in ACE was the soft budget constraint.. An enterprise in a market economy faces a hard budget constraint, as those unable to cover costs, close down. ACE enterprises that do not cover costs are subsidized by the ministry or from state budget. No enterprise is allowed to fail even if AC>price/revenue. 10. Economic growth and technological change: In market economies the incentive to introduce new technology is fostered by the need to remain competitive, by the advantages of cost reduction achieved through new technologies, and through the ability of new products and new technologies to generate market growth and profits. New technologies have many risks and few rewards for the Soviet enterprise manager. Superior technology fails to bring about rewards in terms of higher product prices. If an enterprise introduced a new technology that created a new product but lowered the costs of production, the new product is priced low by existing pricing formulas 11. Problems of Investment criteria/choice: The corporation knows the cost of investment projects and will automatically select those investment projects that yield reasonable rates of return (yearly return/total investment costs). A corporation makes appropriate comparisons of income and costs over time because interest rates allow cumulated costs and benefits to be reduced to a common denominator of present discounted value. (PV= A/(1+i)t) or A/i)). The Soviet enterprise and ministries did not know the costs of investment finance. Investment fianc was provided to the enterprise free of charge. Soviet enterprise faced few incentives to minimize costs of production including capital charges.

Critique of Socialism
12. Consumer Welfare and quantity constraints: Soviet enterprise simply did not produce enough consumer goods to satisfy market demand at prevailing prices . Soviet officials could have responded to excess demand for specific products by allowing prices to rise to their equilibrium levels but they chose not to do so for reasons of income distribution and propaganda. Instead the Soviet authorities used quantity restrictions such as ration coupons requiring people to stand in line to obtain products . When consumer freedom of choice is restricted by quantity constraints (they are allowed to consume only a restricted mount of the product), their consumer welfare declines as compared to unrestricted choice. If Soviet consumers were allowed unrestricted choice of consumer goods, and market prices had been allowed to adjust to equilibrium in all cases, Soviet consumers would have achieved a higher level of welfare with the same amount of production and resources. Quantity constraints have other negative affects on the economy when consumer choices are restricted their earned income becomes less meaningful, why should they work hard, if their ability to buy goods depends not on their income but on their willingness to stand in line. Accordingly the stronger the quantity constraints the weaker the willingness to work. Quantity constraints may also affect the incentive to save. Quantity constraints make people save less and work less. 13. Bureaucratic decision making: Private enterprise managers must weigh the costs and benefits of risk and they are prepared to assume risk as long as marginal benefits exceed costs. If the private decision makers make a risky decision that turns out to be correct they will personally benefit in the form of greater profits, bonuses, stock options. If they approve a risky decision that turns out to be wrong they will personally suffer through lower profits , less valuable stock options or profit related bonuses. The manager of an ACE enterprise have a different attitude toward risk. If a risky decision is taken and the decision turns out to be correct, those who made the decision stand to benefit very little. If a risky decision turns out to be wrong the enterprise or ministry loses as a consequence and those who made the decision are penalized. Asymmetry between risk and reward discourages risk taking in ACE.

Reforming Socialism: Gorbachev, 1985

1. Glasnost: Political Reforms. (i) Envisioned opening of Soviet society through daily discussions, the media, literature, and the conduct of daily life (ii) democratization of daily political life (iii) Democratization also applied to the worker in the enterprise (iv) opening of society will lead to acceleration of economic growth (v) Human factor contributed to the Brezhnev era stagnation of the economy (vi) If workers had increased voice in enterprise and political affairs, less likely to be alienated from economic system (vii) For ordinary soviet citizens to support the Perestroika they must have better understanding of costs and benefits (viii) openness and candor will lesson voices of opposition in CPSU. (ix) Giving more say to Soviet citizens will make them more willing to bear costs of restructuring (x) democratization to increase morale in work force (xi) Glasnost and democratization will enhance Soviet standing in the world (xii) democratization will prepare west to help in Soviet modernization (xiii) Retooling of Soviet factories will be possible.

Perestroika: Economic Reforms

2. Perestroika or The Law of State Enterprises. (i) Less interference in enterprise affairs (ii) Enter. free to enter contracts with other enter. (iii) Ministries and planners to influence actions through laws, rules and norms. (iv) Local units of CPSU to eliminate tutelage of local enter. (v) Local enterprises autonomy. Responsible for results (vi) Enterpr. self financing (vii) investment requirements to be met with retained earnings or bank credit (viii) bonus payments from enterprise profits (ix) no automatic subsidies to unprofitable enterprises (x) No soft budget constraints , Ent. could go out of business (xi) enterprise self management (xii) managers to be elected by worker councils (xiii) retooling of soviet factories through foreign investment/joint ventures (xiv) No foreign trade monopoly by the government. (3) Why Perestroika Failed? (i) Soviet economic performance declined in 1980s. (ii) By late 1980s traditional arrangements of Soviet system were collapsing but nothing was replacing them (iii) Perestroika much less than a comprehensive reform program (iv) An impossible balance between center and local levels (v) little attention paid to changing property rights (vi) enterprises could have contractual dealings but no legal system to enforce them (vii) enterprises freed from rigid input allocation system but no wholesale markets. (viii) bureaucratic resistance (ix) Uncertainty (x) Perestroika supposed to improve Soviet economic performance, it did not. (xi) compared to 1985 output and factor productivity declined in 1989. (xii) Inflation increased by 5% (xiii) Budget deficit increased from 4% of GDP in 1985 10% in 1989 (xiv) 1984 Soviet hard currency debt was $22 B in 1989 it was $44B (xv) value of Ruble against dollar declined (xvi) Huge increase in money supply (1985=4.1BR, 1990=28BR.

Reforms Aftermath: SU Disintegrates

As the economy spiraled downward Gorbachevs popularity sank with it. His authority became threatened by the emergence of a rival power center in the form of the government of the Russian Federation, led by Boris Yeltsin, the chairman of the Russian Supreme Soviet, who had, in July 1990, taken the decisive step of resigning from the communist party. While Yeltsin unequivocally advocated a rapid shift to a market economy, Gorbachev still tended to Gradualism. Consequently although the Supreme Soviet of Russia decided to approve the Yeltsin/Shatalin plan, Gorbachev as the leader of the Soviet Union rejected it, proposing a much slower and less complete transition agenda. In November 1990 the Russian congress of Deputies took the politically charged step of legalizing private family farming, outraging the communists and provoking an irredeemable division . Events of the following year 1991 continued this conflict as the Russian government legislated an even more liberal agenda while Gorbachev attempted to slow the process of reform. Although Gorbachev avoided committing his administration to a radical transformation, his failure to stop Yeltsins program allowed reform to proceed at a pace that alarmed the leadership of the communist party. As Gorbachevs position weakened and the failure of piecemeal reform became more apparent, Western nations, whose financial support was vital to the Soviet Unions reform effort increased, pressure on Gorbachev to adopt a more liberal stance. During the summer of 1991, a group of Soviet reformers and Western academics gathered and drafted what became known as the Grand bargain, under which the SU would commit to rapid economic and political reform, while in return the West would provide substantial economic aid. Gorbachev rejected the plan and tried to negotiate less conditional terms in a meeting of the leaders of the G-7 nations held in London in July, 1991. It was almost his last act as leaders of the Soviet Union and he came away empty handed. While vacationing in Crimea in August, he was the target of a coup led by communist party leaders, which because of an inability to neutralize Yeltsin, unraveled after a few days of chaos. This failed putsch led directly to the breakup of the Soviet Union; during September most of the constituent republics declared their independence . On December 25, 1991 Gorbachev resigned, and over the Kremlin the red flag of the Soviet Union was replaced by the red, white, and blue banner of the Russian Federation. The Soviet Union disintegrates, replaced by 15 independent countries.

Transition to Capitalism
Transition involves the replacement of one economic system with another. 1991 SU collapsed and replaced by the Russian Federation and 14 other independent Republics. The era following the collapse of SU is one of transition. Transition: Initial Conditions: At the time of collapse , almost every major dimension of the soviet economy was fundamentally different from the dimensions of a market economy, even one at a similar level of economic development. The administrative command economy had created fundamental initial conditions different than would have existed under market arrangements. Viewed from a market economy perspective, transition laid bare enormous distortions in the structure of the transition economies . The following table shows some of the enormous differences in initial conditions between the Soviet economy and the market economies. It shows that the structure of the Soviet economy was quiet different from that of the market economies such as the united states. Major Differences Between a Socialist Economy and a Market Economy Structural Distortions of the USSR Economy 1980s ( percent of GDP) Consump. Inv. 53 33 65 17 Ind.& Constr. Agri. Transp. and Comm. Sevices 57 16 9 16 28 3 6.5 44

USSR USA

The table shows that the structure of the Soviet economy was quite different from that of the market economies such as the United States. (i) the Soviet economy over-invested and under-consumed, (ii) produced primary industrial goods (including consumption) and agricultural goods and scarcely produced services. (iii) virtual complete state ownership in the USSR versus modest state ownership shares in market economies (iv) output oriented management practices versus profit maximizing practices , (v) the rule of plan versus the rule of laws of supply and demand, and (vi) administered foreign trade practices versus relatively free trade in USA.

Transition: Initial Conditions

Initial Conditions PPF: We can use the production possibilities frontier (PPF) to illustrate initial conditions, the transition problem, and the issues of sequencing and speed of transition . Figure. shows the Soviet economys production capacities to produce Soviet type (vertical axis) and market type(horizontal axis) goods. The initial mix (choice ) of output favored Soviet Type goods over Market type goods as is shown by point A. The point B shows the desired new production mix for the economy in transition. We measure the opportunity cost of market type goods in terms of the slope of the PPF at various points.

At point A the OC of market type goods is relatively low because few are produced. As the economy moves from A to B the OC of market type goods increases . Resources well suited to the production of Soviet type goods must increasingly be shifted to the production of market type goods . Schumpeter and others recognize that resources must flow from the declining to the expanding industries for an economy to grow. But they recognize that often times resources are slow to withdraw from declining industries because of resistance to change. In SU disruptions caused by enormous shifts in production technology and tastes was huge but Schumpeter said that even under milder conditions the uneven pace of expanding and contracting industries and the difficulty of withdrawing resources from contracting industries would lead to economic decline. According to Schumpeters analysis the movement of output in such circumstances would not be along an existing PPF. But a sharp movement to the interior of the PPF such as from point A to pint C. Thus during the transition the contraction of output in declining industries could be greater than the expansion of expanding industries.

Russian Transition to Capitalism

January 2, 1992 Yeltsin as president of Russian Federation launched a new phase of liberalization of the Russian economy, known as Gaidar Reforms.. (i) Rehabilitatiion of Ruble. The Gaidar teams primary premise was that the rehabilitation of Ruble lie at the heart of any reform program. The Soviet population lost faith in the Ruble as a store of value and opted where possible for dollars or D-Marks, but without a currency in which the population had confidence and which could serve as vehicle for international exchange, they believed that the reform movement could stall. (ii) The second pillar was the creation of a functioning market economy. The January 2 pronouncement ended central coordination of the economy and almost all prices were immediately liberalized, a presidential decree that declared all economic activity to be legal until it was expressly prohibited, reversing the situation that existed under Soviet planning, by which all private economic activity was proscribed unless expressly permitted. The upshot was a massive rise in prices and the considerable monetary overhang came into play as idle savings pursued scarce goods. Inflation during the first week of shock therapy was over 250 percent. Opening the Russian economy to foreign trade resulted in dramatic consequences as consumers who had been required to buy Soviet goods had now greater choice. Imports flowed in and the demand for domestic output fell; for the first time Russian producers faced serious competition in Markets formerly guaranteed to them under planning and decades of neglecting design and quality. Meanwhile , because many raw material could now be exported for hard cash, prices soared from the artificially low levels administered under soviet planning, pushing inflation and hurting domestic production. Price liberalization provided some positive effects; the monetary overhang disappeared as savings were eradicated, the black market was curtailed, and lines for goods, a great source of inefficiency and welfare loss were much reduced. However the distributional consequences were large. Savings in Rubles were wiped out by the plunging value of the Russian currency. The biggest losers were the households, who saw their savings eradicated, and their real wages fall, and any enterprise that held Ruble denominated balances. The gainers were largely the government and the financial sector.

Russian Transition: Privatization

I.Privatization (i) Small scale privatization began with Russian shops and small service establishments, which were handed over to local municipalities who arranged for their transfer usually to their current managers. Agricultural land was decollectivized with members of the collective able to lease land and equipment. Apartments were sold by local authorities generally to their occupants. Those processes started in 1992. (ii)n The Voucher Privatization. Large scale enterprises was privatized under the aegis of the state committee for management of state property, the privatization ministry. Voucher auction was the primary means of transferring ownership. Agriculture: Collectivization under Stalin led to a demoralized and unproductive farm sector and the development of state farms brought little relief. Persistent food shortages bear at least some of the blame for the fall of communism. Even after the collapse of the Soviet Union, privatization of agricultural land , opposed by the remnants of the communist party and the peasants party was slow. Now about 90 % of Russias 190 million hectares (170 million acres) is in private hands. The vast majority of it was handed over to the former collective farmers generally in parcels too small to farm economically. The title to the land is still uncertain and the consolidation of the small holdings into viable farms is but impossible. The same uncertainty coupled with the lack of adequate financial intermediation, make borrowing by farmers for equipment and land improvement difficult in the extreme. Foreigners , particularly West Europeans would like to invest in Russian agriculture, but are denied the legal right to own land. The communist party years killed off the prospect of family farming and the creation of efficient agriculture will be tough as a result. The good farmers are short in supply and so are farm laborers. Despite high level of unemployment, Russians are unwilling to work the land. One solution is the importation of contract farm workers from China, who are happy to work for about $100 per month.

Privatization, Financial Institutions

Privatization Results: (i) By late 1994 and early 1995 the ownership structure of the Russian economy had shifted from government to non-government ownership. (ii) Beginning with virtual full government ownership in 1989 the shares of non-government ownership of K increased in 1993 to 47.2% and to 65% of total capital in 1995 (iii) The share of private ownership of housing stock increased from less than 10% to 40 in 1995 (iv) The share of labor force working in non-government enterprises increased from less than 10 percent in 1985 to 50% in 1995 (v) By 1995 Russian citizens earning almost half their income not through wages and salaries but through earnings from entrepreneurial activities (dividends, profits, and other forms of private income. (vi) Table below shows that the shift from state to private non-state property has also resulted in massive redistribution of income in the direction of greater inequality. Q1 (Poorest 20%) Q2 Q3 Q4 Q5 (Richest 20%) USSR 1991 9 16 20 25 30 Russia 1995 4 10 14 22 50 USA 1995 3.5 12 15 23 46.5

II. Financial Institutions (i) Under the Soviet ACE almost all enterprises owned by the State. They received their investment capital from the state budget. (ii) If a firm were profitable its profits were largely paid into the state budget to finance reinvestment or to finance or investment in other less profitable firms. (iii) Enterprise managers were state employees. They had little or no incentive to maximize profits or to work in other ways to increase the value of enterprise. (iv) The Soviet enterprise working capital was provided from the state budget and managed by specialized banks such as the industrial construction bank. (v) As the transition began, instead of serving as a source of national savings, the fed. budget became a drain on national savings as its expenditure exceeded its revenues..

Financial Institutions and Banking

Supply of Savings: In an economy the supply of savings for investment finance (I) must come from the following sources: I= S+ (T-G) + ( M-X) Private savings depend on interest rates, income, and taxes, SS, dependency ratio. Government savings depend on political process and the state of the economy. The supply of foreign savings depends on relative rates of return and political stability Banking legislations 1992-1995 : (i) 1992 banking legislation called for 2 tiered banking system (ii) The Central Bank of Russia supervises all commercial banks in the country (iii) CBA independent of the government (iv) CBR functions as bankers bank and lender of last resort (v) banking legislation 1995 CBR to defend the stability of Ruble (vi) CBR nor responsible for government debt (vii) (CBR an economically independent judicial person/entity (viii) CBR under the control of Duma (ix) Duma nominates chairperson of CBR for 2 years based on proposal of the president of the Russian federation (x) Twice a year the chairman reports to Duma on banks activities (xi) CBR monetary instruments include interest rate policy, reserve requirements and open market operations, foreign exchange control (xii) controls monetary policy. (xiii) Increase money supply (decrease required reserve ration and discount rate and buy government bonds) (xiv) Decrease money supply (raise RRR, Raise DR and sell bonds)