Globalization and Its Discontents Revisited

by Joseph E. Stiglitz

  The challenges facing the economies of the former Soviet Union and the other Communist bloc nations in transition were daunting: they had to move from one price system—the distorted price system that prevailed under communism—to a market price system; they had to create markets and the institutional infrastructure that underlies them; and they had to privatize all the property which previously had belonged to the state. They had to create a new kind of entrepreneurship—not just the kind that was good at circumventing government rules and laws—and new enterprises to help redeploy the resources that had previously been so inefficiently used.

  No matter how one looked at it, these economies faced hard choices, and there were fierce debates about which choices to make. The most contentious centered on the speed of reform: some experts worried that if they did not privatize quickly, creating a large group of people with a vested interest in capitalism, there would be a reversion to communism. But others worried that if they moved too quickly, the reforms would be a disaster—economic failures compounded by political corruption—opening up the way to a backlash, either from the extreme left or right. The former school was called “shock therapy,” the latter “gradualist.”

  The views of the shock therapists—strongly advocated by the U.S. Treasury and the IMF—prevailed in most of the countries. The gradualists, however, believed that the transition to a market economy would be better managed by moving at a reasonable speed, in good order (“sequencing”). One didn’t need to have perfect institutions; but, to take one example, privatizing a monopoly before an effective competition or regulatory authority was in place might simply replace a government monopoly with a private monopoly, even more ruthless in exploiting the consumer. Ten years later, the wisdom of the gradualist approach is at last being recognized: the tortoises have overtaken the hares. The gradualist critics of shock therapy not only accurately predicted its failures but also outlined the reasons why it would not work. Their only failure was to underestimate the magnitude of the disaster.

  If the challenges posed by transition were great, so were the opportunities. Russia was a rich country. While three-quarters of a century of communism may have left its populace devoid of an understanding of market economics, it had left them with a high level of education, especially in technical areas so important for the New Economy. After all, Russia was the first country to send a man into space.

  The economic theory explaining the failure of communism was clear: Centralized planning was doomed to failure, simply because no government agency could glean and process all the relevant information required to make an economy function well. Without private property and the profit motive, incentives—especially managerial and entrepreneurial incentives—were lacking. The restricted trade regime, combined with huge subsidies and arbitrarily set prices, meant the system was rife with distortions.

  It followed that replacing centralized planning with a decentralized market system, replacing public ownership with private property, and eliminating or at least reducing the distortions by liberalizing trade, would cause a burst of economic output. The cutback in military expenditures—which had absorbed a huge share of GDP when the USSR was still in existence, five times larger than in the post–Cold War era—provided even more room for increases in standards of living. Instead, however, the standard of living in Russia, and many of the other East European transition countries, fell.

  THE “REFORM” STORY

  The first mistakes occurred almost immediately as the transition began. In the enthusiasm to get on with a market economy, most prices were freed overnight in 1992, setting in motion an inflation that wiped out savings, and moved the problem of macrostability to the top of the agenda. Everybody recognized that with hyperinflation (inflation at double-digit rates per month), it would be difficult to have a successful transition. Thus, the first round of shock therapy—instantaneous price liberalization—necessitated the second round: bringing inflation down. This entailed tightening monetary policy—raising interest rates.

  While most of the prices were completely freed, some of the most important prices were kept low—those for natural resources. With the newly declared “market economy,” this created an open invitation: If you can buy, say, oil and resell it in the West, you could make millions or even billions of dollars. So people did. Instead of making money by creating new enterprises, they got rich from a new form of the old entrepreneurship—exploiting mistaken government policies. And it was this “rent-seeking” behavior that would provide the basis of the claim by reformers that the problem was not that the reforms had been too quick, but that they had been too slow. If only all prices had been freed immediately! There is considerable validity in this argument, but as a defense of the radical reforms it is disingenuous. Political processes never give the technocrat free rein, and for good reason: as we have seen, technocrats often miss out on important economic, social, and political dimensions. Reform, even in well-functioning political and economic systems, is always “messy.” Even if it made sense to push for instantaneous liberalization, the more relevant question is, how should one have proceeded with liberalization if one could not succeed in getting important sectors, like energy prices, liberalized quickly?

  Liberalization and stabilization were two of the pillars of the radical reform strategy. Rapid privatization was the third. But the first two pillars put obstacles in the way of the third. The initial high inflation had wiped out the savings of most Russians so there were not enough people in the country who had the money to buy the enterprises being privatized. Even if they could afford to buy the enterprises, it would be difficult to revitalize them, given the high interest rates and lack of financial institutions to provide capital.

  Privatization was supposed to be the first step in the process of restructuring the economy. Not only did ownership have to change but so did management; and production had to be reoriented, from producing what firms were told to produce to producing what consumers wanted. This restructuring would, of course, require new investment, and in many cases job cuts. Job cuts help overall efficiency, of course, only if they result in workers moving from low-productivity jobs to high-productivity employment. Unfortunately, too little of this positive restructuring occurred, partly because the strategy put almost insurmountable obstacles in the way.

  The radical reform strategy did not work: gross domestic product in Russia fell, year after year. What had been envisioned as a short transition recession turned into one of a decade or more. The bottom seemed never in sight. The devastation—the loss in GDP—was greater than Russia had suffered in World War II. In the period 1940–46 the Soviet Union industrial production fell 24 percent. In the period 1990–98, Russian industrial production fell 42.9 percent—almost equal to the fall in GDP (45 percent). Those familiar with the history of the earlier transition in the Russian Revolution, into communism, could draw some comparisons between that socioeconomic trauma and the post-1989 transition: farm livestock decreased by half, investment in manufacturing came almost to a stop. Russia was able to attract some foreign investment in natural resources; Africa had shown long ago that if you price natural resources low enough, it is easy to attract foreign investment in them.

  The stabilization/liberalization/privatization program was, of course, not a growth program. It was intended to set the preconditions for growth. Instead, it set the preconditions for decline. Not only was investment halted, but capital was used up—savings vaporized by inflation, the proceeds of privatization or foreign loans largely misappropriated. Privatization, accompanied by the opening of the capital markets, led not to wealth creation but to asset stripping. It was perfectly logical. An oligarch who has just been able to use political influence to garner assets worth billions, after paying only a pittance, would naturally want to get his money out of the country. Keeping money in Russia meant investing it in a country in deep depression, and risking not only low returns but having the assets seized by the next government, which would inevitably
complain, quite rightly, about the “illegitimacy” of the privatization process. Anyone smart enough to be a winner in the privatization sweepstakes would be smart enough to put their money in the booming U.S. stock market, or into the safe haven of secretive offshore bank accounts. It was not even a close call; and not surprisingly, billions poured out of the country.

  The IMF kept promising that recovery was around the corner. By 1997, it had reason for this optimism. With output having already fallen 40 percent since 1990, how much further down could it go? Besides, the country was doing much of what the Fund had stressed. It had liberalized, if not completely; it had stabilized, if not completely (inflation rates were brought down dramatically); and it had privatized. But of course it is easy to privatize quickly, if one does not pay any attention to how one privatizes: essentially give away valuable state property to one’s friends. Indeed, it can be highly profitable for governments to do so—whether the kickbacks come back in the form of cash payments or in campaign contributions (or both).

  But the glimpses of recovery seen in 1997 were not to last long. Indeed, the mistakes the IMF made in a distant part of the world were pivotal. In 1998, the fallout from the East Asia crisis hit. The crisis had led to a general skittishness about investing in emerging markets, and investors demanded higher returns to compensate them for lending capital to these countries. Mirroring the weaknesses in GDP and investment were weaknesses in public finance: the Russian government had been borrowing heavily. Though it had difficulty making budget ends meet, the government, pressured by the United States, the World Bank, and the IMF to privatize rapidly, had turned over its state assets for a pittance, and done so before it had put in place an effective tax system. The government created a powerful class of oligarchs and businessmen who paid but a fraction of what they owed in taxes, much less what they would have paid in virtually any other country.

  Thus, at the time of the East Asia crisis, Russia was in a peculiar position. It had an abundance of natural resources, but its government was poor. The government was virtually giving away its valuable state assets, yet it was unable to provide pensions for the elderly or welfare payments for the poor. The government was borrowing billions from the IMF, becoming increasingly indebted, while the oligarchs, who had received such largesse from the government, were taking billions out of the country. The IMF had encouraged the government to open up its capital accounts, allowing a free flow of capital. The policy was supposed to make the country more attractive for foreign investors; but it was virtually a one-way door that facilitated a rush of money out of the country.

  The 1998 Crisis

  The country was deeply in debt, and the higher interest rates that the East Asia crisis had provoked created an enormous additional strain. This rickety tower collapsed when oil prices fell. Due to recessions and depressions in Southeast Asia, which IMF policies had exacerbated, oil demand not only failed to expand as expected but actually contracted. The resulting imbalance between demand and supply of oil turned into a dramatic fall in crude oil prices (down over 40 percent in the first six months of 1998 compared to the average prices in 1997). Oil is both a major export commodity and a source of government tax revenue for Russia, and the drop in prices had a predictably devastating effect. At the World Bank, we became aware of the problem early in 1998, when prices looked ready to fall even below Russia’s cost of extraction plus transportation. Given the exchange rate at the time, Russia’s oil industry could cease being profitable. A devaluation would then be inevitable.

  It was clear that the ruble was overvalued. Russia was flooded with imports, and domestic producers were having a hard time competing. The switch to a market economy and away from the military was supposed to allow a redeployment of resources to produce more consumer goods, or more machines to produce consumer goods. But investment had halted, and the country was not producing consumer goods. The overvalued exchange rate—combined with the other macroeconomic policies foisted on the country by the IMF—had crushed the economy, and while the official unemployment rate remained subdued, there was massive disguised unemployment. The managers of many firms were reluctant to fire workers, given the absence of an adequate safety net. Though unemployment was disguised, it was no less traumatic: while the workers only pretended to work, the firms only pretended to pay. Wage payments fell into massive arrears, and when workers were paid, it was often with bartered goods rather than rubles.

  If for these people, and for the country as a whole, the overvalued exchange rate was a disaster, for the new class of businessmen the overvalued exchange rate was a boon. They needed fewer rubles to buy their Mercedes, their Chanel handbags, and imported Italian gourmet foods. For the oligarchs trying to get their money out of the country, too, the overvalued exchange rate was a boon—it meant that they could get more dollars for their rubles, as they squirreled away their profits in foreign bank accounts.

  Despite this suffering on the part of the majority of Russians, the reformers and their advisers in the IMF feared a devaluation, believing that it would set off another round of hyperinflation. They strongly resisted any change in the exchange rate and were willing to pour billions of dollars into the country to avoid it. By May, and certainly by June of 1998, it was clear Russia would need outside assistance to maintain its exchange rate. Confidence in the currency had eroded. In the belief that a devaluation was inevitable, domestic interest rates soared and more money left the country as people converted their rubles into dollars. Because of this fear of holding rubles, and the lack of confidence in the government’s ability to repay its debt, by June 1998 the government had to pay almost 60 percent interest rates on its ruble loans (GKOs, the Russian equivalent of U.S. Treasury bills). That figure soared to 150 percent in a matter of weeks. Even when the government promised to pay back in dollars, it faced high interest rates (yields on dollar-denominated debt issued by the Russian government rose from slightly over 10 percent to almost 50 percent, 45 percentage points higher than the interest rate the U.S. government had to pay on its Treasury bills at the time); the market thought there was a high probability of default, and the market was right. Even that rate was lower than it might otherwise have been because many investors believed that Russia was too big and too important to fail. As the New York investment banks pushed loans to Russia, they whispered about how big the IMF bailout would have to be.

  The crisis mounted in the way that these crises so frequently do. Speculators could see how much in the way of reserves was left, and as reserves dwindled, betting on a devaluation became increasingly a one-way bet. They risked almost nothing betting on the ruble’s crash. As expected, the IMF came to the rescue with a multi-billion-dollar package in July 1998.4

  In the weeks preceding the crisis, the IMF pushed policies that made the crisis, when it occurred, even worse. The Fund pushed Russia into borrowing more in foreign currency and less in rubles. The argument was simple: The ruble interest rate was much higher than the dollar interest rate. By borrowing in dollars, the government could save money. But there was a fundamental flaw in this reasoning. Basic economic theory argues that the difference in the interest rate between dollar bonds and ruble bonds should reflect the expectation of a devaluation. Markets equilibrate so that the risk-adjusted cost of borrowing (or the return to lending) is the same. I have much less confidence in markets than does the IMF, so I have much less faith that in fact the risk-adjusted cost of borrowing is the same, regardless of currency. But I also have much less confidence than the Fund that the Fund’s bureaucrats can predict exchange rate movements better than the market. In the case of Russia, the IMF bureaucrats believed that they were smarter than the market—they were willing to bet Russia’s money that the market was wrong. This was a misjudgment that the Fund was to repeat, in varied forms, time and time again. Not only was the judgment flawed; it exposed the country to enormous risk: if the ruble did devalue, Russia would find it far more difficult to repay the dollar-denominated loans.5 The IMF chose to ignor
e this risk. By inducing greater foreign borrowing, by making Russia’s position once it devalued so much less tenable, the IMF was partly culpable for the eventual suspension of payments by Russia on its debts.

  The Rescue

  Hoping to restore confidence in Russia’s economy, the IMF approved an $11.2 billion loan on July 20, 1997, as part of a $22.6 billion package from international lenders. Russia received $4.8 billion immediately, and this money was spent in a failed attempt to bolster the value of the ruble. The World Bank was asked to provide a $6 billion loan.

  This was hotly debated inside the World Bank. There were many of us who had been questioning lending to Russia all along. We questioned whether the benefits to possible future growth were large enough to justify loans that would leave a legacy of debt. Many thought that the IMF was making it easier for the government to put off meaningful reforms, such as collecting taxes from the oil companies. The evidence of corruption in Russia was clear. The Bank’s own study of corruption had identified that region as among the most corrupt in the world. The West knew that much of those billions would be diverted from their intended purposes to the families and associates of corrupt officials and their oligarch friends. While the Bank and the IMF had seemingly taken a strong stance against lending to corrupt governments, it appeared that there were two standards. Small nonstrategic countries like Kenya were denied loans because of corruption while countries such as Russia where the corruption was on a far larger scale were continually lent money.