Kendrick D. White, the founder and CEO of Nizhny Novgorod-based Marchmont Capital Partners, continues a series of postings sharing his thoughts of where, in his opinion, Russia should go to reinvent itself for the 21st century. In this posting he is trying to identify Russia’s most acute systemic problems.
Well-oiled ups, ill-oiled downs
As an American, I lived my first thirty years in the U.S. where my world view was shaped; I experienced all of the benefits of what the U.S. economic system could offer. As an economist, I had an understanding that Russia’s commodity-driven Command Economy was ultimately unsustainable and would eventually fail under the pressures of rising global trade and regional market integration.
I have spent the past seventeen years of my life living and working full time in Russia. I now have gained unique experiences and insight into the transition which this country is undergoing. So what have I learned?
To begin with, any traditionally-structured commodity economy in the world fluctuates through boom and bust cycles; the economy goes up when commodity prices are high and it comes crashing down and has deficits and defaults when commodity prices fall.
Many people in Russia have unfortunately misunderstood what happened in this country during the last 20 years. Many blamed the regular recurrences of the cyclical economy upon (i) the reform process itself, (ii) privatization, corruption, and in general the chaos that coincided with the start of the conversion of the country’s commodity economy to a more market driven and diversified economy. This explanation is unfortunately too simplistic.
Since 1992, the economy has experienced a number of “ups and downs.” But many people recognize that this crisis environment in Russia is not merely twenty years old, but rather that because of an abundance of oil and gas, Russia has been too reliant upon its oil-based economy for many years.
Since the mid-1960s, the Russian economy has gone up and down, its fluctuation depending on the international price of oil. In 1973 and again in 1979, with the Arab oil embargos, the increased price of oil directly led to an improved economy in the USSR. But, when the prices fell again in the 1980s over a longer time frame, the USSR economy also experienced a long decline leading to the ultimate default of the economy in early 1990s. So high oil prices led to good times, and low oil prices led to bad times, resulting in the final collapse of the Soviet Union and the need for radical market reforms.
This cycle has been repeated in the last twenty years. When the Asian currency crisis hit in 1997, this led to a global financial crisis which dramatically reduced global growth and therefore demand for oil. This again led to the collapse of oil prices and the second default of the Russian economy in 1998.
A commodity bias, deep-rooted and too perilous
Even looking beyond the past 50 years of the oil economy in Russia, it is clear that Russia has consistently been a commodity-driven economy for centuries. For example, in the 1890s, Nizhny Novgorod’s Yarmarka Trade Fair was the central market point where European grain prices were established.
In fact, it is probable that Russian development has been driven by commodity extraction and exports not only for hundreds of years, but for a thousand years. This dependence has profoundly shaped the Russian mentality and sociopolitical system.
While possessing these commodity resources has generated wealth for those at the top of Russia’s aristocracy controlled power system, this socioeconomic structure has delivered much less to the rest of society.
Today, reliance upon commodities now threatens far greater damage to Russia’s place in an innovation-driven world. The entire economy is fundamentally unstable, resulting in regular boom and bust cycles of rapid income growth followed by default as commodity prices rise and fall.
When global commodity prices are high, Russia’s economy expands through selling its exports internationally. When global commodity prices collapse, Russia’s economy also collapses. This creates an inherent instability which today’s leadership in Russia recognizes cannot be sustained as the general population strives to hold onto the gains which it has worked hard to achieve. As Russia’s growing middle class works to continuously generate wealth and improve its standard of living, this growing segment of society will no longer tolerate such an unstable, high risk economic structure.
Reliance upon the commodity economy for a thousand years has created a number of systemic problems which must be addressed and understood deeply and honestly before Russia can make any final transition to a diversified, innovation-driven economy.
As a result of the recent global financial crisis, and the particularly deep impact it had upon Russia, President Medvedev and Prime Minister Putin have fundamentally realized that their primary goal now is to set a new course for Russia’s economic development this century which can lead to the creation of a new innovation-driven national economy.
This idea of an innovation-driven economy is the only real developmental path for Russia in the 21st century, as all other alternatives will leave Russia excluded from any real global leadership and influence. If Russia continues to rely upon the commodity economy, its economy, culture and the country as a whole will be vulnerable year after year to global commodity crises and unavoidable fluctuations.
Further, as the global economy moves towards innovation, any nation relying too heavily upon the purchase of Russian commodities will have little choice except to reduce its dependence upon Russia over time. This movement away from Russia will set the stage for regularly occurring conflicts of interest between Russia and others. This situation will ultimately push commodity-reliant nations such as the U.S., the EU and Japan to seek out new advanced, lower-cost innovative solutions to alternative energy sources, and new generations of power and transport systems which will be less and less reliant upon Russian commodities.
This changing geo-political situation will leave the Russian economy open to greater and greater levels of fluctuation, and increased risks of social disruptions and unrest.
So what are the systemic problems that the Russian economy is facing, and which must be addressed for solutions?
First and foremost, a thousand years of commodity-driven economics has enshrined in the political and business culture an inherent bias in favor of creating and maintaining monopolies. State operated monopolies prevail across the entire economy.
In speaking with private entrepreneurs, it is clear that nearly every businessman has his own goal of becoming a monopolist in his sector and thereby securing monopoly profits. While there is nothing unnatural in this goal of private entrepreneurs, it is up to the role of government to regulate this process and ensure competition in a true market economy. In Russia’s case, a dominating form of State Capitalism has resulted in widespread conflicts of interest between government regulatory bodies, which should be responsible for ensuring open competition, and state-controlled industry.
The Government’s current plans for 2010 and 2011 show that serious efforts will be made to re-invigorate the previously-stalled privatization process. However, it is clear that a new push of stringent anti-monopoly legislation must be developed in parallel to ensure that the state controlled monopolies will not simply be transitioned into privately held monopolies.
As a traditional commodity economy relies upon mass production and export of oil, gas, grains, minerals and other natural resources, consolidated control over these sectors makes it easier to collect these resources efficiently, ship them and collect the fees. Therefore, the ownership of Russia’s natural resources has always tended to be held in the hands of small elites, thus leading to monopolization as a form of political control over the economic system. So it was during the time of the Tsars, and so it was under the leadership of the Communist Command Economy.
The economy has now been in the process of shifting during the past 20 years from a pure command economy under the totalitarian Communist system to a pseudo-market economy dominated by a form of State Capitalism. Nonetheless, private business owners continue to believe that monopolies are the ideal form of business organization.
Unfortunately, the Government has not done enough to create legislation that stops monopolies from forming. Furthermore, it has not conducted enough business education to demonstrate to business leaders the dangers of monopolization.
High profits for the monopolists are made at the expense of the overall culture and the overall competitiveness of the Russian economic system internationally. The result is a far-reaching over-reliance upon monopoly producers across numerous economic sectors in the still semi-isolated regional economies in the Russian Federation.
Many economic problems have resulted, including the problem of single-industry cities, a huge risk of which the President and the Prime Minister are fully aware. Across the country, hundreds of cities are reliant upon a single monopoly producer. On top of this, even across Russia’s regional capital cities where there is an abundance of various industrial enterprises, far too many monopolies dominate the local sectors.
This monopolistic local culture is highly risky in any economic environment and must be dealt with systemically in order to encourage new business formation and development to make the regional economies more diversified and competitive.