The Truth about "Russian Shock Therapy"

A fashionable narrative holds that liberal reforms were principally responsible for the social instability and economic decline that occurred in Russia after the dissolution of the Soviet Union. Upon closer examination, this narrative overlooks some key details of what actually occurred in Russia in what is sometimes described as the “shock therapy” period. It ignores, too, some of the challenges inherited from the historical legacy of a command economy and totalitarian regime that lasted for over seven decades. The partial implementation of reforms, along with the persistence of communist-era economic planning and state intervention, interacted to produce the hyperinflation and widespread corruption that marked this period. The collapse of state authority and the breakdown of law and order also meant that criminal violence and communist agitation provided obstacles and temptations for would-be reformers. These would distort and undermine the post-communist government’s reform program.

A fuller reform program that coincided with more conservative monetary and fiscal policies, stronger protections for private property, and a more aggressive approach in dealing with criminal violence and communist agitation might have yielded better results for Russia.

Shortages and Hyperinflation

After the fall of communism, the most immediate crisis facing the population was severe shortages in the most basic consumer goods. The first major decision facing the post-communist government was an unenviable one: whether to release price controls and risk inflation, or retain price controls and perpetuate shortages. As if trying to split the difference, the government only partially relaxed price controls on consumer goods while retaining them on commodities such as oil and metals. As ordinary consumers faced a price hike, speculators with government positions or political connections acquired commodities at suppressed prices to sell abroad at higher market rates. Prices for basic consumer goods, meanwhile, quite often were not set according to market rates, but instead were artificially inflated by corrupt communist holdovers. The government continued to run high deficits while the central bank issued so much money its printing presses stopped working. 

This toxic combination of continued shortages and corrupt pricing faced by ordinary consumers along with the perpetuation of fiscal profligacy by government authorities produced the first instances of the hyperinflation that began to define what would be called the ‘damned nineties.’

The second major decision was how to sell state assets and enterprises. The official justification for not privatizing state assets through a competitive and transparent market process was to avoid concentrating wealth among the old communist elite. Instead, individual vouchers representing shares in state enterprises were distributed to their respective managements and workforces. 

The dilution of equity in these new cooperatives, a limited understanding of basic concepts in finance and investments, and restrictions on workers’ ability to organize independently that carried over from the Soviet period left these worker-shareholders at an immediate and deep disadvantage with the communist-era managerial elite of these former state-owned enterprises.

In the absence of independent shareholders or corporate directors that might hold management accountable for corrupt or incompetent performance – as with American-style capitalism –      communist-era managers enjoyed greater impunity than had even been the case during the Soviet period. They used it to great effect to disempower the workers under their control and ultimately dispossess them even of the nominal shareholdings they had in the company.

Having only known socialism, workers had no understanding of concepts such as book value, shareholder rights, fiduciary responsibility, or market prices. Worker-shareholders were regularly pressured to surrender their shares at deep discounts. Communist-era managers threatened to dismiss workers who refused, or punished them with delayed wage payments, which in turn caused hardships that made workers desperate for quick cash in exchange for their shares. 

The New Financial Overlords

Meanwhile, the politically connected speculators who had exploited the difference between price controls on commodities and their market rates had reinvented themselves as bankers and lenders with the new wealth they had accumulated. The most prominent and politically connected among them, former Communist Party apparatchik Vladimir Potanin, helpfully suggested that the government effectively outsource the privatization process to him and the other newly minted bankers. The government would receive a $2 billion loan secured by substantial holdings in the remaining state-owned enterprises. If the government defaulted on the loan, these new banks would supposedly organize open auctions where the highest bidders would acquire the equity.     

Whereas other countries in eastern Europe had instituted some degree of accountability for the old communist regimes, there would be no ‘de-communization’ on the same scale in Russia. The Soviet Union never had its Nuremberg.

Auctions were rigged so opening bids were set well below market value while higher competing bids were dismissed as not credible. Foreign investors were barred altogether. The same bankers organizing the auctions awarded themselves the winning bids and then acquired state assets at only nominal prices. This ’loans-for-shares’ scam, as it became known, would mark the transformation of this new banking and commodity trading cartel into what became known as the ‘oligarchs’ as they used their new wealth to consolidate their influence over the government. 

Looked at in isolation, the post-communist government’s approach to price controls and privatizations appears astonishingly inept and corrupt, with insider deals and contradictory half-measures becoming the rule rather than the exception. Critics of capitalism contended these were the natural consequence of the “shock therapy” that had supposedly been implemented. These criticisms do not, however, account for what the post-communist government inherited from decades of communist rule and socialist planning, nor do they account for the political obstacles that blocked their reforms. That explanation also does not account for more successful implementations of “shock therapy” that occurred elsewhere in the former communist states of eastern Europe.

The post-communist government also faced a breakdown in law and order. The mobsters that came to prominence during this period had their origins exploiting inefficiencies caused by the socialist system. Trade and enterprise by private citizens was a crime under communist rule. This meant that even the most basic and necessary consumer staples, if not produced and distributed by state functionaries, could be classified as contraband. The mercantile bourgeoisie that communism promised to eliminate was simply replaced by criminal gangs in the black market. 

As with inflation and corruption, the end of communist rule in Russia did not cause the rise of criminal gangs but simply revealed the depth of the rot. Perverse incentives engendered by socialist planning were exploited by enterprising criminals that saw a need and sought to fill it.

The post-communist government, which was already limited in its political flexibility by the communist holdovers that predominated in the state apparatus and the new parliament, was further hamstrung in its willingness and effectiveness to reform the country by the threats and the temptations presented by preexisting organized crime syndicates left over from the Soviet era.

Return to Despotism

Vladimir Putin’s rise to power then marked the end of hopes for a market economy. State reliance on resource rent-seeking, as was the norm under communist rule, returned to the fore in Putin’s Russia. The emerging private sector shrunk as state control or ownership of property and industry expanded to a third of the workforce, and nearly half the Russian economy.

What remains in private hands Jordan Gans-Morse has called “state predation” whereby any Russian citizen’s property and capital is subject to summary confiscation. Oligarchs are now more intimately tied to the state and dependent on political favors to retain their wealth and status, while one oligarch as recently as 2019 complained that the state has since seized control of 70% of the Russian economy. Whether or not the statistic is accurate or reliable, the state’s control over the economy only seems to be increasing as Russia’s diminished private sector finds itself squeezed between the twin pressures of Western sanctions and the Kremlin’s predations. 

Upon closer inspection, the events that transpired in Russia in the immediate aftermath of the Soviet Union’s dissolutions reveal a reality far more nuanced and complicated than any simplistic narrative of the country being impoverished by the end of communist rule. The continuation of an unrestrained monetary policy and continued subsidies to Soviet-era state enterprises played as much a role in inflation as did the lifting of price controls. What’s more, the political space for liberal reforms in Russia was far smaller than has been appreciated by critics that claim that an unrestrained program of “shock therapy” was forcefully imposed. The insider deals and half-measures that passed for reform in Russia had been shaped and constrained not just by the perverse incentives of would-be oligarchs and their political allies, but by communist opposition that made its influence felt in both parliament and the state apparatus. 

Law and order and the protection of private property are non-negotiable requirements for the emergence and survival of any mature market economy or liberal democracy. 

If the effective toleration of criminal violence by the new government was a major contributor to the failure of reforms in Russia, so too was the relative impunity enjoyed by communists for past crimes and present agitation. Whereas other countries in eastern Europe had instituted some degree of accountability for the old communist regimes, there would be no ‘de-communization’ on the same scale in Russia. The Soviet Union never had its Nuremberg.

The lessons that can be learned and unlearned from Russia’s experience with a post-communist transition involve three key themes. The first and most important involves the overriding and non-negotiable importance of law and order and the protection of private property. Markets can exist in anarchic conditions, but they are unlikely to lead to lasting prosperity and long-term economic growth. Law and order and the protection of private property are non-negotiable requirements for the emergence and survival of any mature market economy or liberal democracy. 

Vladimir Putin has appeared to only partly absorb this lesson given the degree of authority and power that has accrued to the state compared to the anarchic conditions of the 1990s.

The second lesson involves the importance of fiscal and monetary discipline. The easy money policies of both the late Soviet period and the post-communist government almost guaranteed the persistence of inflation risks. This is another lesson that Putin appears to have learned imperfectly. Before the Russian invasion of Ukraine, a more conservative monetary and fiscal policy had been the rule rather than the exception under Putin’s rule in stark contrast to the profligate policies of the government and the central bank that existed under Boris Yeltsin.

The third lesson is that it is necessary to fully implement the prescriptions of so-called “shock therapy” under competitive and transparent conditions, rather than implementing politically constrained half-measures. The easy money policies and excessive restrictions on market competition that existed under the post-communist government were a boon to corruption. This included the haphazard approach to lifting price controls while retaining subsidies and other spendthrift policies, as well as opaque and uncompetitive approaches to privatization programs.     

Finally, the widespread criminal violence that ran rampant in the streets and the communist opposition in both the state apparatus and the new parliament played a central role in diminishing the political feasibility of more complete reforms. It would have been better for the post-communist government to focus on restoring law and order and reining in its budgets before proceeding with politically controversial but economically necessary reform measures.

The alleged consequences of “shock therapy” had more to do with the persistence of old habits than with the implementation of new reforms. To adapt a phrase from G.K Chesterton, the capitalist ideal was not tried and found wanting. It was found difficult and left untried.