Financial Times (UK) 1 August 1998 [for personal use only] RUSSIA: Magic realist economy John Thornhill on the bizarre logic driving the emerging capitalism of Russia Summer in Moscow is an unreal season. As Muscovites cast off their winter cares - and clothes - escaping to riverside bathing holes or country dachas - the city always seems to lose its grip on reality. The mood was captured perfectly in Mikhail Bulgakov's magical novel, Master and Margarita, in which the devil and his associates wander the sunny streets of the Russian capital. The devil's entourage included a big, black cat called Behemoth, who smoked cigars and toyed with his Mauser pistol. This summer too, Moscow has been full of strange sights and events. Water-melons, piled high on street corners, have been mysteriously contaminated with mercury. Mushrooms, plentiful this year just as they were on the eve of Hitler's invasion, have been found to be radioactive. A minor hurricane recently tore through the Kremlin gardens. In this slightly weird world, few things seem more surreal than the Russian economy itself - especially as described in a recent paper by two American scholars, who claim that Russia has created the world's first "virtual economy". Fund managers who last year thought that Russia was one of the great investment opportunities of the 21st century have been passing the article around in trepidation as they watched the value of their share-holdings plummet. "We call the new system Russia's 'Virtual Economy' because it is based on illusion, or pretence, about almost every important parameter of the economy: prices, sales, wages, taxes, and budgets," the two authors, Clifford Gaddy and Barry Ickes, say in a paper for the Brookings Institution. "Over the past six years of 'radical reform', Russian companies, especially those in the core manufacturing sectors, have indeed changed the way they operate. Only, they have done so not in order to join the market but rather to protect themselves against it." The article suggests that the bulk of the country's Soviet-era enterprises is still subtracting value from inputs rather than adding it (this means the value of, say, a Russian fridge is lower than that of the metal, plastic and other raw materials used to make it). In Russia, companies disguise their destruction of value by charging arbitrary prices for their products, the argument goes. The increasing share of barter trade in the economy, which now accounts for half of all economic activity, means this massive bluff has never been called. Companies could pay their suppliers and, until recently, even their taxes with barter goods "priced" far higher than their true market value. It is only workers who do not accept this pretence and want hard cash: hence the problem of wage arrears. Given that bankruptcies are rare, companies are able to stagger on, accumulating massive inter-enterprise debts. Whereas 27 per cent of companies were reporting losses two years ago, 47 per cent are today. Yet these businesses are not restructuring or withering away. Rather they actually increased their total payroll during 1997. The bizarre logic of this "virtual economy" means that, as in the Soviet era, production increases should often be counted a bad thing since they subtract value from the nation's wealth. Similarly, gutting a company of its assets may be a good thing, since it transfers assets into the real cash economy. The IMF's recipe for squeezing more tax out of such enterprises, the authors argue, may only make the economic and social situation worse. In the absence of mass bankruptcies, cash-starved enterprises will simply be faced with the alternatives of paying taxes or wages. "Russia needs to downsize its economy just like Russian companies downsize their businesses. But people still believe in this myth that big is good," argues Boris Jordan, the head of MFK Renaissance, a brokerage house. "It is better to be a profitable oil company with 5bn barrels of reserves than an unprofitable one with 15bn barrels. But people have a hard time understanding that." Over the past year, foreign investors have swung from blind optimism to blind pessimism. At the moment, it seems, some are willing to believe almost anything about Russia's economy - even, in Bulgakov's words: "Well, citizens, we have now seen a case of so-called mass hypnosis. A purely scientific experiment, proving most convincingly that there are no miracles in black magic . . . In a moment citizens, you shall see these alleged banknotes disappear as suddenly as they appeared." -- Gregory Schwartz Dept. of Political Science York University 4700 Keele St. Toronto, Ontario M3J 1P3 Canada Tel: (416) 736-5265 Fax: (416) 736-5686 Web: http://www.yorku.ca/dept/polisci
