Property Rights and Privatization in Russia

After the collapse of the Soviet Union, Russia engaged in the widespread privatization of large corporations with investments from the West. Initially, support for privatization was widespread throughout the world. Eventually, however, it became obvious that the Russian implementation of privatization was rife with corruption, cronyism, and violence. In the early to mid-1990s, the Russian economy shrank to such an extent that Russian citizens supported the deprivatization of the industries that had been privatized only a few years before. Politicians looked for loopholes for declaring that the private equity issues of organizations illegal and void, as a means for local governments to appear stronger and for an increase in the small streams of revenue that trickled in. This collection of events showed some of the erroneous assumptions upon which the push for the rapid privatization was based. In the end, simple economic theory explained the devastation that resulted. Had there been a more analytical assessment of market behavior from the start, the post-Soviet transition might have more successfully created a middle class and functional capitalist system.

Shortly after the dissolution of the Soviet Union, Russian politicians in favor of privatization—which was seen as a push toward Western capitalism—quickly enacted a voucher system of privatization similar to that used in the Czech Republic while they had the political wherewithal to push the reforms through, hoping to refine the process sometime in the future (Appel, 1997). The problem with the system, according to Paul Klebnikov of Forbes magazine, was that the market was flooded too quickly with vouchers, which made them almost worthless (2002). The vouchers had been distributed to Russian citizens in a noble flourish in a fit of political exigency, but the process didn’t take into account simple economic analysis. By increasing supply to such an astronomical level, demand crashed. Many citizens sold their vouchers on the black market for the equivalent of a couple of bottles of vodka (Klebnikov, 2002). In many cases, the vouchers ended up in the hands of the managers and directors of the companies, rather than in the hands of the working poor: an unintended result. As the economy continued to contract, support of the excesses associated with capitalism shrank as well.

Those in positions of power and authority exploited the weaknesses of the system. Corruption, cronyism, and the power of the mafia all led to the system failing to deliver on its promises of new widespread ownership of private property throughout Russia. Some allege that policies should have been liberalized to allow more competition in the marketplace (Boykco et al., 1993, p. 162). Others posit that the West pushed Russia to make sweeping reforms without understanding that those reforms would not work without corresponding social mindset changes related to capital markets (Holmstrom & Smith, 2000). In essence, a capitalist system was created, but capitalists did not magically sprout up overnight to take part in it. Some even allege that Western leaders are at least partially responsible for the criminal class and the disastrous effects on the Russian economy that grew out of the chaos.

The likelihood of privatization led to managers of firms looting the companies and stripping them of their goods and capital assets, trying to rescue or plunder whatever value they could from the company before it was privatized (Sachs, 1992). Companies became even less productive and efficient than they had been during the Soviet era. The rapid upheaval of the system led to a drop in the national income of 50% in fewer than 10 years (Milne, 2001).

By the early to mid-1990s, the Russian economy reeled from the effects of transition policies gone wrong. Russian politicians—encouraged by poverty-stricken constituents—began systematic deprivatizations by having courts declare the prior privatizations illegal and seizing the corporations (Holmstrom & Smith, 2000). Unsurprisingly, Russian citizens looked unfavorably upon reforms that failed to deliver on empty promises.

Investors continue to be scared away by the minimal returns on investment and the unpredictable enforcement of ex post facto laws, increasing the risk versus potential profit equation of investment in Russia. The seizures by the government were favored politically by the Russian people, which pushed some Russian leaders—such as Moscow’s Mayor Yuri Luzhkov—to continue the politically popular crusade (Holmstrom & Smith, 2000). Russians, themselves, are averse to investing in Russian companies because of the high levels of risk for low expected returns for most investors (Holmstrom & Smith, 2000). In the long-term, deprivatization causes a chilling effect on foreign investment as the risk of losing it all to the Russian government becomes too great to be overcome by the possibility of a huge payoff in the form of company profits in the new economy.

In the short-term, Russia arguably gained a minimal amount of increased revenue by taking over the formerly privatized companies. As a country’s economy as a whole shrinks, its citizens are the biggest losers as there is a much smaller pie, regardless of how it is sliced.

Assuming that more people are hurt by deprivatization than are helped by it, a local politician would support deprivatization if he is primarily concerned with short-term effects and the shoring up public opinion—to get voted into office and experience personal gains he stands to make by doling out favors to the oligarchs and Russian mafia leaders waiting in the wings. In a winner-takes-all-environment, there is almost a perverse incentive for a politician to load the dice so he or she stands to gain as much as possible as quickly as possible before another leader takes control.

But this smash and grab mentality leads to risk aversion interfering with investment opportunities. Investors, as a rule, dislike dumping money into a country that does not respect property rights, order, or rules. Even if the potential payoff is very high, political and legal instability in a market will lead to most investors withdrawing their resources and looking for a more predictable environment that will enable them to more accurately predict potential costs and benefits. Thus, ultimately, the policy of deprivatization led to the additional contraction of the Russian economy.

References

Appel, H. (1997). Voucher privatisation in Russia: Structural consequences and mass response in the second period of reform. Europe-Asia Studies, 49(8): pp. 1433-1449.

Boycko, M., Shleifer, A., Vishny, R. (1993). Privatizing Russia. Brookings Papers on Economic Activity 2: pp. 139-173.

Holstrom, N. & Smith R. (2000). The necessity of gangster capitalism: Primitive accumulation in Russia and China. Monthly Review, 51(09).

Klebnikov, P. (2002). Theft of the century: Privatization and the looting of Russia. Multinational Monitor, 23(1-2).

Milne, S. (2001). Catastroika has not only been a disaster for Russia: A decade on, enthusiasm for the Soviet collapse looks misplaced. The Guardian, August 15, 2001. Retrieved from http://www.theguardian.com/world/2001/aug/16/russia.comment

Sachs, J. (1992). Privatization in Russia: Some lessons from Eastern Europe. AEA Papers and Proceedings, 82(2): pp. 43-48.