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Johnson's Russia List


August 9, 1998   
This Date's Issues: 2303    

Johnson's Russia List
9 August 1998

[Note from David Johnson:
1. AP: Yeltsin Rejects Illness Provision.
2. Komsomolskaya Pravda: 'Extracts' From Book on Yeltsin Family 
(By Natalya Konstantinova, fomer press secretary to Yeltsin family)

3. Sovetskaya Rossiya: Communist Party statement, "Against Lawlessness
and Oppression of Reforms."

4. The Sunday Times (UK): Mark Franchetti, Inside Moscow.
5. Interfax: Lukashenka Said Worried by Russian Socioeconomic Situation.
6. Interfax: Yavlinskiy: Autocratic Yeltsin Regime Run Out of Potential.
7. Edwin Dolan: Is there a virtual economy? 
8. Itar-Tass: Chubays, Gaydar Assisting in Russian Privatization Plan.]


Yeltsin Rejects Illness Provision
August 8, 1998

MOSCOW (AP) - President Boris Yeltsin rejected a proposed law Saturday that
would have allowed the prime minister to take over his duties if he were
incapacitated - a touchy issue, given Yeltsin's health history. 

The measure, passed by Parliament last month, is ``conceptually
unconstitutional and is not subject to further consideration,'' Yeltsin said. 

The Russian constitution says a president must step down if he suffers a
``lasting inability to exercise his powers.'' But it provides no mechanism to
transfer power to the prime minister. 

Many of Yeltsin's Communist opponents in Parliament claim a series of recent
illnesses, including a heart attack, have left him physically unfit to hold

Even a top aide to Yeltsin said recently the president was too unhealthy to
run for another term. But Yeltsin has insisted he is fine. 

Under the measure rejected by Yeltsin, the president would have to temporarily
relinquish power if he is hospitalized, committed to a sanitarium or on

Yeltsin argued that a long illness or hospital stay cannot be considered
sufficient grounds for turning power over to the prime minister. 

It was not clear whether he formally vetoed the bill or merely refused to sign


'Extracts' From Book on Yeltsin Family 

Komsomolskaya Pravda 
1 August 1998
[translation for personal use only]
"Extracts" from book by Natalya Konstantinova under the
general heading "I Am Not Being Allowed to Publish Kindly Book
About the Yeltsins" -- first paragraph is introduction
[Former Press Secretary to President's Family]

We are familiarizing Komsomolskaya Pravda readers with extracts from
the as yet unpublished book.
[Konstantinova begins] I remember my first days working in the
Kremlin because they were full of a kind of general and very touching
feeling of closeness to everyone who was worried about the president day
and night and fighting for him to recover. We spoke without any ceremony
whatsoever -- nurses and Doctors Akchurin, Vorobyev, and Mironov were
coming and going and holding serious discussions just two steps away from
us, and when we three -- Naina Iosifovna [Yeltsina], Tanya [Tatyana
Dyachenko], and I -- saw the next day the results of the interview, people
came to us several times from the president and chivvied us along: "Boris
Nikolayevich wants to go for a walk, he's waiting."
I remember that we sniggered at the question of a relationship between
Tatyana and Anatoliy Chubays (all sorts of rumors were circulating in
Moscow at the time). Naina Iosifovna could never believe that people were
saying such things, and she was amazed by everything. We were thinking
that at least something nonetheless ought to be said about it to make
everyone finally back off. Our answers were rather highfalutin, and that
just made people laugh even more. We finally decided that if we went on
taking this so seriously, we would end up with a joke about "How Tanya and
Tolya became friends...."
It turned out that people were gossiping about me too, in an attempt
to make up some nonexistent romance between me and Sergey Yastrzhembskiy. 
And this happened after I had been dismissed from the president's Press
Service. So I am well acquainted with what such cases are worth. After a
while, having read several articles about the president's family in the
foreign press, I repeatedly mentioned this to Tatyana, but my arguments met
with no particular success....
In general, relations between the female side of the Yeltsin family
and the press were difficult, to put it mildly. Naina Iosifovna liked
journalists, but at a distance -- consequently, she had to be talked into
each interview at length. Tatyana still hides herself away, even though it
is high time she told some major newspaper about what Boris Yeltsin's image
adviser actually does.
Because of all this, a lot of our splendid projects fell through --
including the "A Day in the Life of the Russian President's Family" project
with Time magazine, "Naina's Russian Kitchen," a photofeature on Tatyana in
Paris Match, and others. Paradoxically, when what she saw as an
unflattering photograph appeared in some publication, Tatyana was surprised
and asked me how they could have gotten hold of it. That was, at the very
least, a strange question. First, these were often photographs taken by
the President's dismissed personal photographers Sokolov and Donskoy;
second, there were simply pirated shots for which the publishers themselves
-- not the president's Press Service -- were responsible.
I told Tatyana -- let's take some good pictures that you'll like,
distribute them to the news agencies, and solve this issue once and for
all. Nobody would hunt the president's daughter, monitoring her in
doorways from around the corner! But even these arguments of mine drew a
A few minutes later Lena, the Yeltsins' elder daughter, looked in, and
said that "Dad's getting very impatient." I made my excuses, went
downstairs, and almost bumped into Boris Nikolayevich (at the time he had
never been officially photographed during his illness, not even by his
personal photographer), who, without waiting for his family, was already
sitting on a bench by the entrance to the department in a fur hat and warm
I darted into my car and, when I got home, told everyone I knew with
some delight that I had seen the president alive and well at very close
She was called Anastasia, but she entered adult life with the name
Naina. A fairytale, romantic, unusual-sounding, and rather un-Russian
name. Maybe her grandmother cast a spell for her to have this fate, and
the strange name of Naya became her guiding star. She never asked
soothsayers to divine her future, but a combination of circumstances --
including tragic ones -- as it were prepared her for this unusual but
nonetheless happy life.
She suffered the tragic death of her father and two brothers under the
wheels of a car, and that fear for her nearest and dearest was rooted in
her heart forever -- consequently, all these years she has been scared of
cars and aircraft and admitted that "I really like having my two feet on
the ground."
All her life she has remembered her grandmother's words: "Never do
anyone a bad turn." That is why she has always shunned anything dark,
incomprehensible, or unfamiliar. She has always believed that she has no
enemies, but subconsciously all these years she has protected herself and
her family -- like any woman -- from hostile, prying eyes.
At 24 she married a man who many years later would be elected the
first Russian president. For a long time Boris Yeltsin could not get used
to the name Naina and simply called his young wife "my girl."
Probably the first time they wore wedding rings at the same time was
in the fall of 1996, when both were in the hospital. At the time of their
marriage, many years previously, there had simply been no money to buy
wedding rings. But their children gave them this gift to mark the 40th
anniversary of their life together. At one of the most difficult times of
their lives they were truly betrothed in the presence of their extended
family -- two daughters and four grandsons. "We were both in the hospital.
And suddenly our daughters came in with flowers and a small dish. I asked: 
'What's in that dish?' They came up and said: 'Exchange rings.' I even
thought about having a wedding ceremony, but I hadn't asked my husband --
although he probably would not have been against it. But I didn't want to
make a public event out of it," was Naina Yeltsina's recollection of that
In his youth, when money was available, the future Russian president
had not bought a ring, but later, after the betrothal in the hospital, he
wore it for several months. But Naina Yeltsina has not taken off the thin
ring that she bought for herself after the wedding -- people do not really
wear two wedding rings in Russia.
Incidentally, few politicians in Russia emphasize their family status.
Neither Viktor Chernomyrdin, nor Anatoliy Chubays, nor Boris Nemtsov wears
a wedding ring. But Yuriy Luzhkov, Andrey Nikolayev, and Sergey
Yastrzhembskiy do....
Naina and Boris Yeltsin seem to have suited each other from the
beginning. He is the obvious leader -- big, booming-voiced, implacable. 
She is the secret leader, a kind of "thing unto herself," she seems to be
going along with her husband, but is actually always making the decisions
about everything herself. He is extremely open, sometime more than is
required for a politician of this level, and is sometimes not very mindful
of what he is planning to say. She is emotional, but only outwardly --
inwardly she opens up only to those who are very close to her. He is
decisive, never looking back (at either people or events), living each big
busy day one day at a time. She seems to always be apologetic, but she
wins people over very strongly. Nonetheless, Naina Yeltsina is a pretty
strong and determined woman. Obvious leaders such as Yeltsin are usually a
bit scared of their wives or, at any rate, they listen to them.
Perhaps during these 40 years she has missed out on some warmth and
concern -- but what woman would admit to that out loud. Only once did she
disclose in a conversation about family life with her younger daughter
Tatyana: "If only my husband spent every minute kissing me like your
Lesha" (Lesha, Lenya, Leonid Dyachenko is Tatyana's husband -- N.K.).
In 1950 Naina (she was still Anastasia Girina at the time) entered the
Construction Faculty at the Urals Polytechnical Institute (Sverdlovsk --
N.K.), graduating as a construction engineer in 1955. She already knew
Boris Yeltsin, but they "fell in love" in the second year. She became his
wife in 1956. A year later their daughter Lena was born, and another three
years later, little Tatyana....


CPRF Calls for 'All-Russia Political Strike' 

Sovetskaya Rossiya
6 bAugust 1998
[translation for personal use only]
Communist Party of the Russian Federation Central Committee
Presidium statement "Against Lawlessness and Oppression of

As we know, the State Duma, after a careful discussion, rejected a
number of draft laws from the package of so-called anticrisis measures
proposed by the government. The draft laws which increased the tax burden
on the majority of the Russian population and primarily on working people
were not approved.
But the president and government, in violation of article 75 of the
Russian Federation Constitution, by their edicts and decrees are putting
into operation the norms of the rejected draft laws and new taxes. There
has been an increase in payments into the pension fund from wages and in
the land tax rates. Import duty has been raised. "Temporary" special
customs duty is being introduced on white sugar and raw sugar and the 10
percent value-added tax rate has entailed a similar increase in prices for
a number of necessities.
The question of altering the size of pensions, which is contrary to
common sense and the Constitution, has not been finally eliminated.
At the same time the Russian Federation president rejected the laws on
the reduction the reduction of the rates of profit tax and oil excise duty,
which were supported by the Federal Assembly.
The government believes that by its anticonstitutional measures it can
compensate for the losses which have arisen in connection with the
"uncooperative" deputies' rejection of the draft laws submitted to them. 
Here no one is saying how much prices will rise and how far the
population's living standard will decline. After all, taxpayers will have
to pay over 100 billion rubles for the latest experiment by the executive
There is no doubt that the implementation of these unlawful measures
will lead to a further reduction of production, a rise in unemployment, and
the intensification of tension and social stratification in society.
The executive organs of power in the Federation components, which are
obliged to effect the illegal levies from the population, are also in a
difficult position.
Yet again the president and his government are ostentatiously ignoring
the Federal Assembly decisions. Yet again the president and the executive
branch are taking their meager funds from millions of people, as happened
with the liberalization of prices, voucherization, and the devaluation of
Thus the 100 days of S. Kiriyenko's government have failed to take the
country a single step forward toward a way out of the increasingly
deepening crisis.
The president is continuing to encourage the intervention of
international financial structures in the Russian Federation's internal
affairs. Here information on the terms on which foreign credits are being
obtained is being withheld from the Federal Assembly and the people, which
is giving rise to entirely justified suspicions that these terms are
The way the president and government are ignoring the demands of the
protesting miners, teachers, machine builders, and scientists is provoking
a new conflict among all branches of power whose consequences could be very
The CPRF [Communist Party of the Russian Federation] Central Committee
Presidium urges the CPRF party organizations to do everything to support
the Russian citizens' demands and their protest against the executive
branch's tyranny.
We denounce the anti-people policy of the president and government and
demand the repeal of the unlawful edicts and decrees. We urge all patriots,
all the dispossessed, and all those who hold dear the Motherland's fate to
involve themselves actively in the preparation of an all-Russia political
strike whose ultimate goal should be the repeal of the present course, the
president's resignation, and the creation of a government of the people's
[signed] The CPRF Central Committee Presidium, 3 August 1998.


The Sunday Times (UK)
9 August 1998
[for personal use only]
Inside Moscow
By Mark Franchetti 

Murder puts the chess candidate in check 

For Kirsan Ilyumzhinov, the flamboyant chess-mad leader of Kalmykia, it 
was meant to be the event that finally put his tiny Russian republic on 
the map - and launched his candidacy for the Kremlin in the 2000 
presidential elections. However, plans by the former millionaire 
businessman to host next month's international chess Olympiad, the 
biggest fixture in the game's annual calendar, are being overshadowed by 
the suspicious death of one of his fiercest critics. 
Russian human rights activists are urging national chess federations to 
boycott the Olympiad following the murder two months ago in Kalmykia of 
Larisa Yudina, a local campaigning journalist. Yudina, who repeatedly 
accused Ilyumzhinov of corruption, had been working on a story on the 
funding of Chess City, the grandiose complex that is being built on the 
outskirts of Elista, the drab local capital, to house the 2,000 
competitors and officials. 

"Chess City, where you will stay and play, has been constructed on money 
obtained by violations of all conceivable laws and human rights," said 
the letter, whose signatories include Sergei Kovalyov, a former adviser 
on human rights to President Boris Yeltsin. 

Although the Kalmyk authorities - who shut down Yudina's newspaper 
several times - have strongly denied any involvement in her death, the 
Kremlin called it a political killing. Whatever the truth, it does not 
bode well for Ilyumzhinov's bid for the Kremlin. 

A former chess champion and current head of Fide, the world chess 
federation, Ilyumzhinov, 35, became one of Russia's first millionaires 
while in his twenties. He was elected president of Kalmykia, an 
impoverished Buddhist region on the steppes of southern Russia, in 1993 
after distributing $100 (£60) bills to voters. 

Far from keeping his promises, Russian human rights activists allege 
that Ilyumzhinov built Chess City with federal funds earmarked for 
industrial and agricultural development and helping the republic's poor. 
"You have the right to know where you are going, who your host will be 
and that tears and poverty are the real cost of this festival," their 
letter warned. 

I spy a used car bargain 

Desperate to raise funds to finance its operations, the FSB security 
police - the cash-strapped successor to the KGB - is auctioning three of 
the black Zil limousines used during Soviet times by Mikhail Gorbachev, 
the former Kremlin leader, and other communist dignitaries. The heavily 
armoured cars, locked away in a KGB garage for 10 years, are more than 
15ft long and are equipped with air conditioning and electric reclining 

With starting prices ranging from £16,000 to £24,000, the FSB hopes the 
auction will attract the likes of the Sultan of Brunei. There could also 
be interest, however, from less affluent buyers such as the Russian 
farmer who recently paid £6,000 for a used KGB Chaika - a more modest 
version of the Zil. "He asked if he could rip out the car's back seats 
to make room for milk churns and if it could negotiate a field," said 
Igar Ushakov, an FSB official. "We told him it was an automatic and was 
unlikely to be able to move through the mud." 

Horoscope for Boris 

Russia is facing a hot political autumn, according to the country's most 
influential forecaster, President Boris Yeltsin. A rival group of 
fortune tellers, however, foresees more dramatic events. 

They predict that in the last months of 1998 Yeltsin will resign because 
of health reasons, Viktor Chernomyrdin, the former prime minister, will 
be killed in street riots and Boris Fyodorov, the brash new tax 
minister, will be assassinated by the former KGB. 

Anatoli Chubais, who heads the Kremlin's drive to reschedule its foreign 
debt, will survive the year unscathed, only to succumb to a rare 
venereal disease in 2013. 

•Frustrated with the poor condition of the roads in Lebedyan, his home 
village in central Russia, Leonid Mulyarchik has taken matters into his 
own hands and is building an underground system. Mulyarchik, 67, has dug 
a tunnel more than 1,200ft long since starting work in 1991. He has yet 
to reveal whether he also intends to supply the underground train. 

•Naked soldiers may soon become a common sight in Izobilnyy in southern 
Russia after a local laundry refused to return washed linen to recruits 
until the military honours several months' worth of debts. The laundry 
claims it cannot afford to pay wages, electricity or water bills and is 
threatening to hold the linen as a ransom until the army surrenders. 


Lukashenka Said Worried by Russian Socioeconomic Situation 

Minsk, Aug 4 (Interfax-West)--Belarusian President Alyaksandr
Lukashenka is worried over the socioeconomic tension in Russia.
"If this Titanic sinks, it will drag down everybody, not just
Belarus," he told Interfax Tuesday.
The increasing tension in Russia is one of the reasons why he is
making an increasing number of trips to harvesting areas of Belarus,
Lukashenka said. "Harvesting must be a success so as to assure food
security," he said.
He is partly worried over tensions in Russia "because Belarus's policy
is oriented to Russia," Lukashenka said. "If any upheavals occur there, it
would be painful for me as a political figure," he said.
"Russians must overcome the situation. We are prepared not only to
express sympathy but also to participate in every way in stabilizing the
situation in Russia," Lukashenka said. Stability in Russia is a major
ingredient of stability in Belarus, its ally, he said. "If the Union of
Belarus and Russia succeeds in stabilizing the situation in Russia, this
will be of great importance for us," Lukashenka said.
He expressed hope that "There will be no socioeconomic upheaval in
"Times will be difficult for us in Belarus, too. True, this republic
is more manageable than Russia," Lukashenka said. Control, in particular
economic, was lost in Russia in the course of what was called market
reforms, he said. "The market reform and changes in Russia have failed,"
Lukashenka said.
Still, the situation can be remedied, he said. "Control can be
regained. People feel that order and discipline are needed, as in Belarus
after the presidential elections. For this reason if the authorities want
to govern, they can do so," Lukashenka said.
"Even if an upheaval does occur, I do not think it will affect the
Union of Belarus and Russia," he said. "Difficult times bring peoples
together, they sober up and bring the leaders closer together," Lukashenka
said. "The deterioration of the socioeconomic situation in Russia will not
result in any disasters in relations with Belarus," he said.


Yavlinskiy: Autocratic Yeltsin Regime Run Out of Potential 

MOSCOW, July 30 (Interfax) -- Head of Yabloko movement and its Duma
faction Grigoriy Yavlinskiy thinks that "the political regime President
Boris Yeltsin has built around himself using the omnipotence given to him
by the constitution has exhausted its potential."
"The regime has nothing more to offer," he told Interfax and Mayak
radio station before going on leave.
"This political regime was formed by Yeltsin as a regime of personal
autocratic power," he said.
"Yeltsin believes that the more authoritarian his government is, the
less possible various putsches, coups and other unconstitutional
developments are," Yavlinskiy said.
"However, in reality the higher the degree of Yeltsin's autocracy, the
greater the threat of coups," he said.
He said the very style of the regime, "its nervous impulsive movements
greatly resemble agony."
In order to resolve the problems facing the country "the deeply
corrupt, immoral and economically harmful link between money and power,
between businessmen and the government, between business and the Kremlin
must be torn," Yavlinskiy said.
"The Russian political strategy should be much less dependent on
outside influence, much more concentrated on our own interests and take
into account on much a greater scale that Russia does not have permanent
enemies or friends but has permanent interests," he said.
Russian policies "must be formulated so that all key political forces
would agree at least on major issues," he said.
"Then Russia will be able to gradually get up from its knees and maybe
even make up for lost time," Yavlinskiy said.
"The next elections in Russia will not be elections of a person or
even a program, but an answer to the question of whether Russia will remain
an independent national state in the next century," he said. "Such is the
price of the nation's choice and actions this autumn and during the next
elections," he said.
"If the 1995-1996 (Duma and presidential) elections did not teach
people anything, if people did not draw conclusions from them, we will have
to stay for very long time in the state in which we are today," Yavlinskiy


From: (Edwin G. Dolan)
Date: Sat, 8 Aug 1998 
Subject: Is there a virtual economy?

Is There a Virtual Economy?
Edwin G. Dolan
American Institute of Business and Economics

Several JRL contributions lately have focused on the problem that
privatization has failed to produce an efficiently operating market economy
in Russia. As economists put it--using a broad term that encompasses a
variety of market-oriented behaviors, including changes in product lines,
production technology, organization, marketing, and capital structure that
aim to reduce costs, raise productivity, and increase the value of
output--privatization has failed to bring "restructuring."
This is a matter of central importance. Back in early days of reform, many
Western advisers (myself included) took the view that the form of
privatization-vouchers, buy-outs, give-aways, whatever-was a secondary
issue. Whether formerly state property ended up in the hands of party
bureaucrats, workers, Red Directors, or simple thieves, it was argued, the
new owners would be motivated to maximize the value of their property. If
they were not competent to do so themselves, they would, to best serve their
own self-interest, realize the value of their loot in a lump sum by selling
out to someone who would undertake the needed restructuring. Adil Rustomjee
(JRL 2300), relates this view to the "Coase Theorem," although I imagine
that Coase himself would turn over in his grave at this application of his
idea. In any event, the failure of privatization to bring more rapid
restructuring is, together with profound mismanagement of monetary and
fiscal policy, a principal reason that Russian reform has stalled out.
It is instructive to compare the pessimistic tone of recent writings (e.g.,
Michael McFaul, JRL 2297) with the now rarely heard triumphalism of, say,
Anders Aslund's "How Russia Became a Market Economy."
Clifford Gaddy of The Brookings Institution and Barry Ickes of Penn State
have made a major contribution to this discussion with their writings on the
"virtual economy." (JRL 2275, JRL 3329,, etc.) Their main thesis
is that much of Russia's economy is engaged in value-destroying activities
(production of "soft goods") rather than value-adding activities (production
of "hard goods") and that Western aid providers are often mistakenly
encouraging growth of the virtual economy.
Gaddy and Ickes emphasize that firms prefer to produce soft goods because
these can be bartered in the virtual sector even though they cannot be sold
profitably in the market sector. Given the lower transparency and the
greater ease of tax evasion associated with barter transactions the managers
can skim off more for their personal accounts than they can by making and
selling hard goods. They can also enter into mutually beneficial barter
transactions with value adders like Gasprom by which the virtual sector
obtains an in-kind subsidy while Gasprom reduces its tax liability.
However, as Robert McIntyre (JRL 2295) points out in his comments on John
Thornhill (JRL 2293), the "virtual economy," like many a winged phrase,
carries with it a temptation to oversimplify. The phenomenon of the virtual
economy is a complex one, and no single characteristic of the Russian legal
and economic environment explain its persistence. Furthermore, as Frederick
Kaegi points out (JRL 2298), G&I's contention that the virtual sector is
healthy, or even growing, may be an exaggeration.
Clearly the whole idea of the virtual economy needs a closer look. Let's
examine the concept under three headings: Characteristics of the virtual
sector, factors that incline firms to prefer operation in the virtual
sector, and factors facilitating operations in the virtual sector. Doing so
may help formulate some ideas about what, if anything, can be done to
redirect Russian policy toward true market reform. 

Characteristics of the virtual economy vs. the real economy

(1) Barter vs. money. This is almost the defining characteristic of the
market economy for G&I.

(2) Value destroying vs. value adding activities. G&I also emphasize that
much activity in the virtual economy produces goods that have a market value
less than the market value of their inputs. However, McIntyre is right to
caution us that this distinction must be used with care. There are many
cases where the distinction between V-D and V-A activities is a matter of
perspective. Examples: (i) a firm with large sunk costs may add to GDP by
producing a product worse less than long-run total costs (including
replacement of capital) until its capital is fully depreciated. (ii) The
nominal wage rate may overstate the opportunity cost of labor, as evidenced
by the reluctance of workers to leave their jobs even when not fully paid.
(iii) An activity or product may be value-adding at one interest rate and
value-destroying at another. As financial theorists know, there may even be
multiple cross-over points as interest rates rise or fall. (iv) As Dorothy
Rosenberg (JRL 2301) notes, there is also the issue of appropriate
technology. We used to live in a Moscow apartment with an old ZIL
refrigerator (going strong at 30) that had a lock on the door, just like a
lock on a car door. Does putting a lock on a refrigerator add value? It does
if you live in a communal apartment!
All in all, the V-D/V-A distinction is important, but the line is not so
sharp as it appears at first glance, and as McIntyre notes, V-D activity is
by no means rare even in advanced economies.

(3) Soft vs. hard goods. If we define soft-goods as those produced by V-D
activity, this is the same distinction as (2), but still it is a useful
addition to terminology. Among other things, it highlights the fact that the
line dividing the barter sector from the market sector is not always the
same as that dividing the V-D sector from the V-A sector. Market-oriented
firms can, and often do, barter their outputs. This is common among
entrepreneurial startups, not to mention Gasprom itself, the archetype of a
V-A firm operating in the barter sector. At the same time, soft goods can
often be sold for cash. As G&I point out, it may be worth selling soft goods
even at a loss to meet a pressing cash constraint. This past week ORT's
Vremya did a series on Yakutia's gold mines, which, according to the
commentator, now works ores so poor that they incur costs that exceed the
value of their output. But the sector is still major cash cow.

(4) The virtual sector does not restructure. This might seem obvious, but it
is worth saying explicitly. Virtual-sector firms don't shed labor, they
don't invest, they don't change their Soviet-era product lines, etc. Why
not? It's not obvious why not. Even if you are going to specialize in
production of soft goods and market them through the barter economy, don't
you still have an incentive to minimize costs, e.g., by shedding labor?

(5) There is little investment in the virtual sector. Again, it is not
obvious why not. If institution conditions make it possible to extract
substantial incomes from the virtual economy, why shouldn't it attract new
capital? (We return to this below)

(6) The virtual sector is dominated by privatized firms. Perhaps it needs to
be emphasized more often that the "private" sector in Russia contains two
very different kinds of entities, namely, privateIZED formerly government
firms, and entrepreneurial start-up firms. Although the latter may often
participate in barter, they are not part of the virtual economy. They
invest, minimize costs, and otherwise behave like market entities, at least
given the weird constraints they face.

(7) Virtual sector firms are managed by Red Directors rather than the new
manager/entrepreneur class. G&I tend to downplay low managerial skills or
ideological factors as causes of the virtual economy in favor of rational
response to constraints. This is good economics, but it probably shouldn't
be taken too far. The attitudes and skill-sets of the Red Directors are
probably of real importance.

(8) Virtual property rights of directors differ from nominal property
rights. It is implicit (not often enough explicit) in G&I that the managers
of virtual sector firms can and do act independently of the nominal owners
of those firms. Despite possible ideological or paternalistic inclinations,
they are basically out to maximize their personal wealth. Financial
theorists call this an "agency problem." There is a huge disconnect between
maximization of the manager's wealth and maximization of shareholders' net
present value (let alone the firm's net contribution to GDP).

>From this laundry list of traits, we can form a "virtual economy
hypothesis," implicit in G&I: The hypothesis is that there exists a
significantly dense cluster of firms in one sector of 8-space that share all
or most of these traits. Without this clustering, it wouldn't really make
sense to speak of the virtual economy as G&I do. For example, suppose there
were no correlation between the likelihood that a firm produces soft goods
and the likelihood that it disposes of them by barter rather than cash, or
that there were no correlation between the percent of a firm's business done
by barter and the career background of its director. Lack of such
correlations would rob the concept of the virtual economy of much or all of
its value. A subsidiary G&I hypothesis is that the virtual economy not only
exists in this sense, but is stable or even growing.

Characteristics that incline a firm to prefer the virtual economy

In order to believe in the virtual economy hypothesis, we should be have
reasons to think that firms would prefer operating there. What are they?

(1) The effective tax rate is lower for barter transactions. This is too
familiar to require elaboration. Barter transactions are inherently
nontransparent and hard to audit. It follows that a firm's after-tax net
income from V-D activities can be greater than its after-tax net income from
V-A activities even if the latter produce greater before-tax value.

(2) Low transparency of barter transactions facilitates skimming. Even a
sole proprietor or a manager that was a good agent for the company's
shareholders might prefer the barter economy for tax reasons. Over and above
this, as a separate consideration, the manager who is inclined to steal from
his shareholders is very likely to find it possible to skim a higher
percentage of each low-transparency barter transaction than of each
more-transparent cash transaction.

(3) Restructuring may not be an option. Many privatized firms have initial
endowments of capital, labor, and natural resources that add up to negative
net worth when evaluated at market prices, even if the valuation factors in
the restructuring wisdom of the world's smartest consulting firms. To give
this category a name, let's call them "inherently nonviable" firms. If they
were put up for bid in a market economy, either no one would bid on them, or
the only bids would come from scrap-metal dealers. However, this does not
mean that they are useless as a source of wealth given the rules of the
virtual economy. 

(4) High interest rates (or more generally, high opportunity cost of
capital). Let's suppose we set to one side the catagory of inherently
nonviable firms for whom restructuring is out of the question from the
start, and look at those that could rationally be restructured given the
proper management and incentives. We can call these "potentially viable."
However, to become actually viable, they need capital. Capital is expensive
in Russia today. Real interest rates on loans are in the stratosphere, and
equity capital can be attracted only on the basis of very high expected
returns. Thus many potentially viable firms may prefer to stay in the
virtual economy, and in doing so, may so deplete their initial resource
endowment that they eventually become inherently nonviable. There is another
consideration here, as well. From the director's point of view, there is an
additional cost of capital: Bringing in new capital may require losing
control, increasing transparency, losing the right to skim, losing some of
those valuable "virtual property rights." 

(5) Red Directors have good relational capital but weak market skills.
"Relational capital" is the felicitous term G&I give to the web of contacts
and the negotiating skills that the Red Directors inherent from their Soviet
past. Take a potentially viable firm, put a Red Director in charge, and he
may best be able to get rich by operating in the virtual sector. Put a
Wharton MBA in charge of the same firm, and she may be able to get richer by
restructuring and joining the market sector.

(6) Political/ideological motives. These probably can't be neglected. There
is a paternalistic streak in many Red Directors, who actually see it as
their duty to act as little gods providing (awful) jobs to all of their

Characteristics that facilitate a firm's operations in the virtual economy

Whatever the inclination of a manager to operate in the virtual sector, it
would not be possible to do so unless certain institutional conditions
existed that made it possible to operate there. Hence the need to look
separately at conditions facilitating operation in the virtual economy.

(1) Weak corporate governance means owners do not control managers. This
hardly needs elaboration. It is especially, but not exclusively, important
for firms with worker-shareholders. It is also true for firms with
government ownership stakes (e.g., the notorious "Trust Agreement" that let
Gasprom itself manage the government's supposedly controlling block of
stock.) Among firms that have succeeded in attracting outside investors,
both domestic and foreign, stories of minority shareholders victimized by
dilution scams, transfer pricing, etc. are a staple of the Russian business

(2) Weak court/bankruptcy system means creditors have no leverage over
managers. This is a separate but no less important problem from the problem
of corporate control.

(3) Subsidies are available from value-adders, maybe also local governments.
Refer to G&I for the story on how V-A firms subsidize V-D firms within the
virtual economy. Local governments may also provide subsidies out of corrupt
or employment-maximizing considerations.

(4) Government's willingness to accept taxes in kind. This formalizes the
factor mentioned above, that tax rates are lower in the barter sector.

Can Anything be Done?

To say that the pace of restructuring in Russia's privatized economy has
been a disappointment is now a truism. Whether there really is a "virtual
economy" in the sense of a tight, stable cluster of firms fitting the
stereotype perhaps needs further empirical demonstration. A battle of
anecdotes (Kaegi vs. G&I) turns up examples on both sides, and some that are
hard to evaluation. For example, where do we put AvtoVaz? With its ancient
technology and its labor inputs of 450 hours per car, 23 times the Japanese
norm it looks like the classic value subtractor. Kadennikov is certainly the
stereotypical Red Director. Barter, nontransparency, tax and wage
arrears-everything fits. Yet even AvtoVaz, with its unparalleled stock of
"relational capital," is faltering. Its volume production is set to fall by
some 20 percent this year after peaking in 1997. Is it a case in favor of
the virtual economy hypothesis, or proof that value-destroyers are dying

Whether or not we endorse the strong form of the virtual economy hypothesis,
however, we can ask whether anything can be done to (take your choice) break
its hold or hasten its demise. Here are some policy options that seem to
follow from the above analysis:

(1) Cut taxes. Yes, Russian taxes are too high, not too low. They drive
people into the virtual economy. The alternative strategy, which would be to
collect taxes from the virtual economy at the same or higher rate as from
the market sector seems to be a nonstarter. If it isn't producing value,
what is there to tax? As a footnote (a point G&I note) it would also help if
the tax authorities stopped accepting tax payments in kind, a practice that
exacerbates the problem of the virtual economy.
It is interesting to contemplate whether the approach to tax reform
embodied in the current crisis program is a step in the right or the wrong
direction. On the face of it, the purported aim of cutting tax rates while
increasing compliance makes sense, as does the aim of shifting some of the
tax burden from firms to consumers. On the other hand, when we read that the
crisis program includes a 4-year tax holiday for AvtoVaz, at the same time a
big push is made to collect taxes from small and medium businesses, we
wonder. As a Moscow Times commentator recently wrote, "if you use dynamite
to catch fish this year, there won't be any fish next year."

(2) Cut interest rates. There is a widespread view that high interest rates
don't matter for Russian industry because Russian firms don't borrow from
banks. I think this is wrong. First of all, there is just one big pool of
capital in any economy, and if the cost of capital is high at points here
the rates are visible (e.g., when the government sells bonds), it must also
be high at other points (e.g., when firms are trying to attract equity or
simply deciding whether to invest retained earnings in their own firms.)
Second, it is possible, even likely, that the reason that firms aren't
borrowing from banks is because interest rates are high. Even for
potentially viable firms on the border between the virtual and market
sectors, there are not necessarily a whole lot of projects that have a real
internal rate of return of 60 percent per year.
High barriers to international capital flows are also part of the problem.
Interest arbitrage isn't working very well when real interest rates in
Russia are forty times higher than those in the United States.

(2) Devalue. Devaluation would potentially have two beneficial effects.
First, at least if we believe the standard textbook models, exchange rates
are determined by the intersection of supply and demand curves for the stock
of a nation's assets. At any moment, an infinite number of possible
equilibrium real exchange rates are possible, each associated with a
different equilibrium interest rate. To maintain a high real exchange rate,
you have to have a high real rate of interest. Devalue, and you should get a
lower rate of interest. On this point, as on many others, it seems to me
that he burden of proof lies on those who maintain that the standard
textbook model doesn't apply to Russia, not on those of us who say that it does.
The other beneficial impact of devaluation is would be to shift the
frontier between the virtual and market sectors. One reason among many that
it is hard to make money in the market sector is that goods sold there
compete with imports. Devaluation would take a little of the competitive
pressure off, and possibly make it worthwhile for some firms to restructure
that do not find it worthwhile at current rates. Maybe at a lower exchange
rate, Rosenberg's sturdy old Russian refrigerators would win back market
share from the crummy Finnish imports.

(3) Improve corporate governance. OK, easier said than done. But it needs to
be said again and again. After all, what is a capitalist economy? It is one
in which OWNERS OF CAPITAL exercise control over the capital that they own
for the purpose of maximizing the rate of return on their investment.
Probably this was the single area in which foreign advisers were most naive
regarding privatization, especially where mechanisms of dispersed ownership
were envisioned, as with vouchers, mutual funds, worker-shareholders, and so
on. Even in the US economy, the problem of making sure that corporate
managers act in shareholders' interests is far from trivial and far from
solved. In Russia it is the very essence of the difference between
"civilized" and "wild" capitalism.

(4) Improve bankruptcy procedures. In some cases, no doubt, barter
transactions and payment arrears represent a way of doing business that is
mutually preferred by buyer and seller. But too often the creditor is an
unwilling participant in the system with little legal recourse.

None of these suggestions is very original. Unfortunately, inasmuch as all
of them either seem to run contrary to or be low priorities among the
policies of the current Russian government, none of them is very likely to
be implemented, either. 


Chubays, Gaydar Assisting in Russian Privatization Plan 

Moscow, 29 Jul -- Anatoliy Chubays, the Russian president's special
representative for liaison with international financial organizations, and
Yegor Gaydar, director of the Institute of Economic Problems of the
Transitional Period, are playing an active part in drawing up a new
blueprint for privatization in Russia. This was announced today by Russian
State Property Minister Farit Gazizullin at a Ministry of State Property
hook-up conference with territorial property funds.
He said that many prominent Russian economists were also helping to
draw up the blueprint. It will probably be submitted for State Duma
consideration in September, Prime-TASS was told.



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