Shock Therapy Economic Subordination Sham Stabilization

1. Shock TherapyEconomic Subordination Sham Stabilization Robert Stack Ishay Hadash

2. Shock Therapy • Definition: Rapid and radical implementation of market privatization and trade liberalization, intended to create socioeconomic change. • Thesis: Long Russian stagnation with new government power created a political support in Shock Therapy. One can argue, that foreign influence together with social need for change, inspired the new economic path.

3. 1918 vs. 1992

4. Economic advantages • Educated population • Skilled Labor • Widespread of technological and scientific expertise • Abundant natural resources

5. Shock Therapy: beneficiary or hostage of the West? • Administrative command: domestic market • Shock Therapy: foreign intervention • In 1992 Yeltsin stormed parliament and changed policy from gradual to radical economic transformation. • IMF held Russia hostage because of her national debt • Removal of financial support through ending subsidies and trade taxation

6. Short Run consequences • GDP level was ½ after the economic reform • Steep decline in standard of living • Crime rates skyrocketed • Wealth distributed among small portion of the population • Increase in mortality rates and sharp decline in education levels.

7. IMF • Shock Therapy in Russia was essentially a copy of the IMF plan to 3rd world countries. • Complete price liberalization • Supported high exchange rate of Ruble • Removal of tariffs for complete trade liberalization • Swift privatization and fiscal austerity

8. Effects • Government reforms led to high inflation • Decline in population purchasing power • Foreign goods had economic advantage • Discourage investment and saving • Self-perpetuating cycle of increased tax arrears to firms due to increase in inflation for firms

9. Tariffs • Import tariffs and Export tariffs removed • Bankrupted domestic producers of agricultural and manufactured products due to inability to compete with foreign producers • Imported goods increased by 50% between 1994-1997 • Exports of raw materials expanded • Decline in Tariff Revenues compensated by increase in taxes

10. Why IMFs plan failed • Russia lacked financial institutions that other countries have after 70yrs of communism • Severe organizational defects • Firms suffered from difficult financial transition • Lack of currency control by central bank • Capital Equipment outdated and averaged 15yrs • Oil and gas industry are dependent on world energy prices • Russian people could not obtain even basic needs

11. Sham Stabilization • President Yeltsin reelected to office in 1996 • Attempt to balance the economy by stabilizing the currency, issuing government bonds, and lowering the lending rates • Temporary improvement in real wages and rising domestic demand was a misconception for the real performance of the economy • Fiscal deficit remained substantial • Ruble crisis of 1998

12. IMF Paper • Initial Conditions – “On the eve of the Russian financial crisis, Macroeconomic indicators for central Asia had shown major improvements with respect to 1992-1994…data for the region showed that a recovery of economic activity was finally underway… Private and public consumption were growing rapidly following a recovery of real wages (1996) “ (Page 5) • Paper indicating the effects of Russian crisis on the region • Quote indicate the “Bubble Economy” created in the Region • https://www.imf.org/external/pubs/ft/wp/2001/wp01169.pdf

13. Stabilization • Shock Therapy components included: • “Liberalization”- International trade and capital flow • “Privatization”- Private ownership • “Stabilization”- balance the value of the currency The Russian government accomplished the first two components but never succeeded in stabilizing the Ruble (1992- Aug 17,1998)

14. Money The ruble was held at artificially high exchange rate resulting in high interest rate Foreigners purchased high yield short term government bonds high interest rates lead to more foreigners borrowing, which in turn causes appreciation of the ruble In 1998 there was a $6 billion dollar deficit in current account

15. Money • After 1998 foreign investors withdrew assets and capital flight resulted out of fear of default • Fiscal deficit forced government to borrow more, while interest rates continued to climb causing them to borrow even more. • In 1998 debt servicing by the government increased from 14% to 50% of federal revenues • By 1999 Russia was scheduled to pay $17 billion to foreign creditors which was equivalent to the entire federal deficit

16. Taxes • As a result of lower production tax collection decreased • Moral Hazard: Profitable firms not willing to pay taxes • Nonprofitable firms could not afford to pay taxes • Amnesty for tax debts was possibility • Firms engage in illegal/hidden money transactions away from the tax system • In 1998, tax arrears were 2½ times greater then the market money supply

17. Conclusion • Shock Therapy: Drowned into economic system that didn't fit the social, cultural, and financial needs of the country • Economic Subordination: Western influence guided economic transformation from domestically driven to foreign governance • Sham Stabilization: Attempt in balancing the economy ignored required reforms in fiscal investment, tax collection, and capital flight

18. Refrences • Klein, Lawrence and Pomer, Marshall. “The New Russia: Transition gone awry”. Stanford, California: Stanford University Press, 2001. • Damjanovic, Tatiana and Pastor, Gonzalo. “The Russian financial crisis and its consequences for central Asia”. International Monetary Fund,1998. Retrieved: November 29, 2009 https://www.imf.org/external/pubs/ft/wp/2001/wp01169.pdf