By the Early 1980S the Crisis of the Soviet Economy Had Become Acute, and While No Sector

By the Early 1980S the Crisis of the Soviet Economy Had Become Acute, and While No Sector

22 Reform of the Russian Economy

BOX 1

Area (thousand sq. km.) / 17,075
Currency / ruble
Population 2000 (millions) / 146
Population Growth Rate 1990-2000 / -0.2%
GNI per capita 2000 / $1,660
GNI per capita PPP 2000 / $8,030
GDP Growth 1990-2000 / -4.8%
Inflation Rate % per annum 1990-2001
Value Added as % of GDP 2000 / Agriculture / 7%
Industry / 38%
Services / 56%

By the early 1980s the crisis of the Soviet economy had become acute, and while no sector was doing well, agriculture and consumer goods were faring particularly poorly. The system was sustained only by the hard currency proceeds of oil and gas exports used to buy food and advanced capital goods. Despite exhortation to improve economic performance, the leadership seemed determined to change nothing, and stagnation resulted.

Poor economic performance meant that the Soviet Union’s relative position in the world was slowly sinking, and with it the capacity to maintain superpower status. Slippage was accelerated by emerging payments problems in the 1980s; hard-currency exports (mainly energy) peaked in the early 1980s, while imports, including food, continued to rise throughout the decade. The result was a growing external deficit and increased international indebtedness. The gross debt (i.e., what the Soviet Union owed the Western nations before making allowance for Soviet holdings of hard currency) rose from $11.5 billion in 1975 to $22 billion in 1980 and $38 billion in 1985. A measure of the scale and severity of this indebtedness is the debt service ratio (the amount of hard currency payments required annually as a proportion of normal hard currency earnings); it rose from 10 percent in 1975 to about 23 percent in the mid-1980s. Almost a quarter of the value of the Soviet exports was committed ahead of time to repaying previously incurred debts. Market economies faced with such a crisis could finance part of their balance of payments deficit through incoming foreign direct investment, but despite a lukewarm commitment to joint ventures, the reality of Soviet politics made such inflows all but impossible.


Gorbachev’s reform efforts will forever be associated with the catchwords “perestroika” and “glasnost,” usually translated as restructuring and openness. His original intentions were modest, but the political change initiated by his glasnost policy far outstripped his plans for the economy, and Gorbachev was swept further toward liberalization as he attempted to appease both domestic and international critics. While perestroika seemed to offer much at the time, in retrospectthis meandering attempt at reform must be judged a failure. The six years of the program may be divided into four phases, which may be summarized as follows:1


I1985–early 1986Rhetorical period. A lot of talk about reform but few specifics.

II1986–early 1988Legislative period. Creation of superministries, new laws on self-
employment, state enterprise, cooperatives, and property.

III1988–1989Attempted implementation of reform.

IV1989–1991Failure, abandonment of the perestroika model in favor of more radical reform.

While these stages were not totally distinct, this partition gives an overview of the history of the Gorbachev years. Immediately after he came to power, Gorbachev talked a great deal about the necessity of reform and the gains to be made, but his rhetoric obscured the vague nature of his program. What was clear, and remained the case throughout his administration, was that he aimed to modify a socialist economy rather than to shift toward a true market economy.

During 1986, decrees and laws designed to reform the economy began to dribble through. In some ways the legislation was schizophrenic. While it laid the groundwork for private property and market signaling, it increased government control by heaping new powers on the center and creating “superministries.” The most notorious of these was Gosagroprom, designed to coordinate all agricultural and food distribution activity, but it only increased mismanagement and confusion. Gorbachev’s agenda for industrialization hinged on three important laws and one decree:

1.The Law on Individual Economic Activity (November1986) allowed the establishment of small businesses in the service sector as individual proprietorships under license from the state.

2.The Law on State Enterprise, passed in mid-1987 and effective as of January1, 1988, gave much greater freedom to the management of state-owned industry. Hard planning targets were replaced by “state orders” and greater latitude was permitted in staffing, price, and choice of technique. Theoretically, enterprises were to become financially independent and accountable, initiating a “hard-budget constraint.”

3.The Law on Cooperatives (May1988) sanctioned the formation of larger private businesses. For ideological reasons they initially had to take the
legal structure of cooperatives, but in reality this law facilitated the eventual creation of joint stock companies.

4.The Decree on Property (December1988) allowed the sale of state-owned housing to individuals, creating a housing market and leading to the privatization of 12 million homes by 1995.

Although these reforms seemed far-reaching, their effect on the economy was mostly negative. The Law on State Enterprise gave firms both the incentive and opportunity to sell their goods in the market place for the highest prices that they could command, rather than continue to supply their traditional buyers at the prescribed plan prices. As a result, “downstream” firms frequently found themselves short of necessary inputs or unable to pay the higher prices and had to curtail production. Some enterprises even found themselves without the cash flow required to pay their workers. Coal miners, for example, were not paid for long periods in the later years of the Gorbachev administration, although the mines continued to operate and produce coal. Viewed from almost any perspective within the economy, perestroika was not a success.


The failure of Gorbachev’s conception of perestroika and the protracted decline of the Soviet economy pointed to the need for more radical reform. The experience of the previous four years showed once again the ineffectiveness of tampering with the basic system of command planning, and consequently more attention was paid to moving the economy of the Soviet Union directly to a market system. In early 1990 a committee established under the leadership of Stanislav Shatalin, a respected economist and academician, produced a document known as the Shatalin report, titled 500 Days: Transition to Market. It was deeply critical of the foundations of the Soviet system of centralized planning and sought to replace it with private property and liberalized market prices.

The long rule of the totalitarian socio-political system dragged our society into profound crisis. Indecisiveness of the government and the mistakes it made in economic policy brought the country to the brink of collapse.... For a long time economic policy did not consider the people’s interests. The state was wealthy while the people were poor. The state accumulated under its control almost all of the resources for production. Such resources were squandered on giant and ineffective projects, for increasing military power, and for certain ideologically flavored practices overseas even though the times have long passed since we could afford this.2

After attacking the leadership, the system, and Gorbachev’s halting and ineffectual reforms, the report provided a rationale for a new order based on market relations. In retrospect, and given the disappointments of the decade since the report, the idea that the Soviet economy could be put on a market footing in only a year and a half seems naive, but it did represent fresh and open thinking on the causes of and the potential solutions for the Soviet malaise.

As the economy spiraled downward Gorbachev’s popularity sank with it. His authority became threatened by the emergence of a rival power center in the form of the government of the Russian Federation, led by Boris Yeltsin, the chairman of the Russian Supreme Soviet, who had in July1990 taken the decisive step of resigning from the Communist Party. While Yeltsin unequivocably advocated a rapid shift to a market economy along the lines of the Shatalin report, Gorbachev still tended to gradualism. Consequently, although the Supreme Soviet of Russia voted to approve the Shatalin plan by a margin of 213 to 1, Gorbachev as leader of the Soviet Union rejected it, proposing a much slower and less complete transition agenda. In November1990 the Russian Congress of Deputies took the politically charged step of legalizing private family farming, outraging the Communists, and provoking an irredeemable division.

Events of the following year, 1991, continued this conflict as the Russian government legislated an ever more liberal agenda, while Gorbachev attempted to slow the process of reform. Although Gorbachev avoided committing his administration to a radical transformation, his failure to stop Yeltsin’s program allowed reform to proceed at a pace that alarmed the leadership of the Communist Party. As Gorbachev’s position weakened and the failure of piecemeal reform became more apparent, Western nations, whose financial support was vital to the Soviet Union’s reform effort, increased pressure on Gorbachev to adopt a more liberal stance. During the summer of 1991 a group of Soviet reformers and Western academics gathered and drafted what became known as the Grand Bargain, under which the Soviet Union would commit to rapid economic and political reform, while in return the West would provide very substantial economic aid. Gorbachev rejected the plan and tried to negotiate less conditional terms in a meeting with the leaders of the G7 nations, held in London in July. This was almost his last act as leader of the Soviet Union, but he came away empty-handed. While vacationing in the Crimea in August, he was the target of a coup led by Communist Party leaders, which because of an inability to neutralize Yeltsin, unraveled after a few days of chaos. This led directly to the breakup of the Soviet Union; during September most of the constituent republics declared their independence, and by March only the Ukraine and Belarus remained. On December25 Gorbachev resigned, and over the Kremlin the red flag of the Soviet Union was replaced by the red, white, and blue banner of the Russian Federation.


Dramatic economic reform immediately followed. On January2, 1992, just eight days after Gorbachev’s resignation, Yeltsin, as president of the Russian Federation, launched a new phase of liberalization of the Russian economy. The chief architect of this new plan was Yegor Gaidar, a young liberal economist whose voice had become increasingly influential. The Gaidar/Yeltsin plan was spurred by Western criticism and resembled the Sachs/Balcerowicz plan initiated in Poland the previous year with some success3 and rested on five “pillars.”4

(1) Rehabilitation of the Ruble

The Gaidar team’s primary premise was that the rehabilitation of the ruble had to lie at the heart of any reform program. The Soviet population had lost faith in the ruble as a store of value and opted where possible for dollars or D-marks, but without a currency in which the population had confidence, and which could serve as vehicle for international exchange, they believed that the reform process would stall.

(2) Market Liberalization

The second pillar was the creation of a functioning market economy. This involved decontrolling prices, allowing free entry into almost all economic activity, cutting back on the share of output absorbed by state orders, and establishing the necessary legal system required to underpin market activity. The January2 pronouncement ended central coordination of the economy, and almost all prices were immediately liberalized.5 Later that month, Yeltsin made a presidential decree that declared all economic activity to be legal unless it was expressly prohibited, reversing the situation that had existed under Soviet planning, by which all private economic activity was proscribed unless expressly permitted.6

The upshot was a massive rise in prices and the considerable monetary overhang came into play as idle savings pursued scarce goods. Inflation during the first month of “shock therapy” was over 250 percent, and the prices of many key consumer goods rose by much more. The force of inflationary pressure surprised many observers, including the International Monetary Fund (IMF), which had held the opinion that a rise in prices of only 45 percent would be enough to neutralize the monetary overhang. Opening the Russian economy to foreign trade also had dramatic consequences as consumers who had been required to buy Soviet goods now had greater choice. Imports flowed in, and the demand for domestic output fell; for the first time Russian producers faced serious competition in markets that had been guaranteed to them under planning, and decades of neglecting design and quality showed. Meanwhile, because many raw materials could be now exported for hard cash, prices soared7 from the artificially low levels administered under Soviet planning, pushing inflation and hurting domestic production.

Price liberalization had some positive effects: the monetary overhang disappeared as savings were eradicated; the black market was curtailed; and lines for goods, a great source of inefficiency and welfare loss, were much reduced. However, the distributional consequences were large. Savings in rubles were wiped out by the plunging value of the Russian currency. Table 22.1 gives some data on the extent of this redistribution. The biggest losers were the households, who saw their savings eradicated and their real wages fall, and any enterprises who held ruble-denominated balances. The gainers were largely the government and the financial sector.

TABLE 22.1

Winners and Losers in Russia’s Inflation 1992–1993,
Percentage of GDP, 1993

LossesGainsNet Gain



Financial sector0818




SOURCE: William Easterly and Paula Vieira da Cunha, “Financing the Storm: Russia’s Macroeconomic Crisis,” Economics of Transition 2, no. 4 (1994).

The inter-enterprise payments system began to break down. Many firms were unable to pay the higher input prices since they were not receiving payment for
the goods they sold and delivered. Not out of choice but out of necessity, enterprises began to extend credit to each other, creating a precarious pyramid of inter-enterprise debt. Insolvent firms ceased to pay their workers; as personal incomes fell, so did demand, creating more insolvencies. Although the linchpin of the Gaidar plan had been monetary restraint, the worsening economic situation raised pressures to liberalize credit. Lobbying from the enterprises was intense, and the growth of inter-enterprise credit led to the justifiable fear that the collapse of a few firms could lead to catastrophic domino consequences. So relunctantly the government, through the Central Bank, loosened credit and provided cheap loans (often at negative real interest rates) to bail out the industrial sector, causing excessive growth of the money supply.

(3) Privatization

The third pillar of the Gaidar program was mass privatization, deemed imperative for three main reasons. First, policy makers felt that the burden of subsidizing state enterprises could be sharply reduced, or even eliminated, once these firms had passed in private hands.8 This would help to put public finance on a more stable footing and reduce the reliance on credit creation to keep enterprises solvent, thereby eliminating a source of inflation. Second, for reasons discussed earlier, it was expected that private management of resources would lead to greater efficiency. Third, large-scale privatization would be hard to reverse and would therefore reinforce political change because the new owners would oppose retrogression thereby “locking in” the gains of economic and political liberalization.

(4) Constructing a Social Security System

The Soviet Union lacked an adequate system of unemployment compensation, which had been regarded as unnecessary in a society where unemployment notionally did not exist, and was, in fact, illegal. However, if the efficiency of industry was to be increased, sweeping changes in employment practices would be required, and raising labor productivity had to involve, at least in the short term, the shedding of excess labor. Without a “social safety net” to catch the unemployed there was a distinct possibility of increasing social unrest.9

(5) Converting the Defense Sector

The great paradox of the Soviet economy was the coexistence of a world-class defense and aerospace sector with consumer goods and housing sectors that simply failed to deliver the goods. The key had been the high degree of prioritization that had locked up over 30 percent of Soviet gross domestic product (GDP) in defense, and with it most of the nation’s able engineers and managers. It was hoped that “defense conversion” deploying the skilled labor and sophisticated apparatus to peaceful purpose could provide a dynamic sector around which to focus Russia’s development effort.