Clifford Gaddy is a fellow in Economic and Foreign Policy studies at the Brookings Institution and one of the most respected analysts of the Russia economy in the world today.

His groundbreaking article, "Russia’s Virtual Economy," co-authored by Barry Ickes, exposed the myths of the reform effort in Russia through the 1990s, and has since become a cornerstone of analysis of the country.

The Russia Journal asked Gaddy about the Russian economy’s recent past, its status today and its prospects for the future.

THE RUSSIA JOURNAL: A lot of people are talking up the Russian economy today, pointing to the record trade surpluses and the revival of domestic industry after the crisis. Has Russia really turned the corner after a decade of decline?

CLIFFORD GADDY: I think it’s too early to say that Russia has turned the corner. Of course there are a number of positive signs, aggregate indices like GDP growth or industrial growth look good, inflation looks good and the trade balance is extremely positive.

But I think when you disaggregate that and look at the micro-level there are some more worrisome signs. Perhaps not really disturbing signs as yet, but they certainly should give us pause, and cause us to ask what exactly is going on with the Russian economy and what are its longer-term prospects.

RJ: Let’s look at those long-term prospects. To what extent has the reform implemented prepared Russia for long-term growth?

CG: What one has to be aware of when posing the question, "How have the reforms undertaken during the Putin administration affected Russia’s longer-term prospects for growth?", I think we have to keep in mind that there are really two distinct categories of economic reforms that affect the Russian economy.

The first are the kinds of reforms that are consistent with the development of a market economy but are not undertaken primarily for the purpose of making Russia a market economy. They are undertaken primarily with the objective of strengthening the state.

And again they may be consistent – that is they don’t contradict the goal of developing a market economy – but they’re not undertaken primarily for that purpose. A good example is tax reform: The primary purpose of tax reform is to bring in more money, more resources especially to the central government. At the same time clearly a simplification and a streamlining of the tax system is a worthy goal and consistent with market reform.

There is, however, another type of economic reform that is absolutely essential for the development of Russia as a competitive market economy and yet is threatening to the stability and therefore to the strength of the Russian state.

Those kinds of reforms I am referring to are the ones that would affect especially Russia’s core enterprise sector, its manufacturing industries, most of which – or at least close to half of which – are simply not competitive, and not even potentially competitive under normal considerations of the amount of investment that would be needed to bring them to a competitive level, it would simply require too much money, it wouldn’t be worth it.

And that means that certain reforms would threaten the survival of those enterprises and bring with it a degree of social and political instability that is unacceptable in Russia today. It requires too much dislocation, too much hardship for too many people, too many regions, too many cities in Russia to be a practicable alternative right now.

So, Russia has during these past three years since the crisis of 1998 undertaken reforms of the first type – those that are designed to strengthen the stability and power of the state – but has consciously refrained from undertaking the second type of reforms, which would threaten the stability of the state.

And yet the dilemma for Russia is that the second type of reform is absolutely essential if Russia is going to be competitive as an economy in the longer term. And again, I think that’s the real dilemma facing the current administration: There are a number of things the Putin administration has done and will continue to do to extract resources for a kind of growth, from what is there in the economy right now. And the most fundamental of those is to try to stop some of the looting and leakage of value, if you like, from the Russian economy; to try to rein in the oligarchs and their pure looting of the economy.

But you know there’s a limit to how much you can achieve with that approach. Beyond that you need to have new sources to generate new wealth in the economy, and that requires developing whole new businesses, reallocating the resources you have, the people you have, so that they’re producing new products, new services, in probably new places – new physical geographical locations in Russia than some of the activity is right now. And that is a huge process that in my opinion would be more revolutionary, more disruptive than everything that’s happened so far since 1991, and that means it’s quite a big process, it is not something that would be easily undertaken.

RJ: Are we talking here of the military-industrial complex, and what else?

CG: You can begin with the heaviest of Russia’s heavy industry. And now there are some metallurgical plants that are profitable. But when you get into processing and fabrication, that’s where the problem is concentrated, and certainly the former defense-industry sector is the biggest part of that problem, but it extends beyond just defense plants. It includes many plants that produce civilian products. It also includes a number of facilities that comprise the light-industry sector – that is textiles and clothing and things like that that are just simply not going to be profitable.

RJ: It’s a bleak picture you paint. Is there any chance that you can grow the newer aspects of the economy in tandem with the gradual phasing out of the older? Or does there have to be a fundamental break – despite the fact that it’s politically and socially impossible?

CG: My sense is that as much as you would like to try to find the gradual alternative, to gradually phase out the old as you grow in the new – I simply don’t think that that’s possible because of the relative proportions between the two in Russia. The non-viable sector is simply too large. It’s going to suck resources from the new parts of the economy as they grow.

The solution, at least one possible solution, and it’s very difficult as well, is basically making the choice of following the idea of letting some parts of the economy survive on their own. It means surviving at a low level, kind of a subsistence level, while you try to concentrate your efforts and your resources, your best resources, in certain selected parts of the economy.

And I think in Russia it needs to be combined with a regional approach. It’s not simply choosing certain enterprises or certain sectors, but for Russia’s long-term viability, one of the worst legacies it brought forward from the Soviet period was the physical location of so much of its industry in the coldest areas of the country: I’m not only talking about Siberia, not just Eastern Siberia and the Far East; but also even Western Siberia and the Urals. These places are very, very cold relative to the rest of the world. They are also cold relative to where Russian industry was located before the Soviet industrialization campaign.

In effect, what I’m saying is that for long-term viability I think Russia is going to have to be moving back to the European heartland, and concentrate the development of its new viable industries there. And actually encourage the movement of people back away from Siberia and the Urals, where they ended up through the Soviet collectivization and industrialization programs.

RJ: There tends to be a love-hate relationship toward Russia in the West, and we seem to be entering the former again. Do you sense the beginning of a situation akin to 1996-97 where people are getting enthusiastic and again forgetting to look at the realities of the economy?

CG: Yes, there is a tendency to go to extremes with Russia. This does bear some resemblance to the 96-97 euphoria. But, quite honestly, I feel that there is more moderation in it, for precisely the reason that people, though memories are short, they’re not quite that short, and there is still this notion of caution: "Remember what happened last time." And the euphoria is not as strong and as universal as it was then. So this is the good news, that there is somewhat more moderation.

I do think that people even now are not looking at the fundamentals, even the official statistics should be enough for some caution, as we see that the extremely high rates of growth, industrial growth, GDP growth, of a year ago, are quite considerably lower now.

I have a sense that when you look at the Russian economy today, this is something like what we’re going to have for the next few years, so let’s talk in those terms. The oil price certainly remains a critical element. But it’s not as if the entire economy is going to rapidly go up and down in tandem with the oil-price increases and decreases.

There is a stability that has been achieved in Russia that is good because it’s stable – it’s bad because it’s not dynamism. This is not a dynamic economy, it’s not an economy that is bursting out at the seams – one that is growing, developing new things.

You know, one of those facts or statistics that you can cite to remind you as a cautionary note of what’s really in people’s behavior, and the Russian economy, is the statistic about how much of the food is being grown on the private plots. If indeed, the Russian economy had taken some radical steps toward a real market economy in the past three to four years, we would see, I think, and hope to see, a decline in the amount of time and effort people are spending growing their own food – they would begin to rely on the market. And this has not happened at all in the last three years.

Over 90 percent of the potatoes are still grown on people’s dacha plots. So people, ordinary Russian citizens, are quite understandably, quite rationally, pretty cautious about this. They may be optimistic, they may be hopeful, but it’s an attitude of "I’ll believe it when I see it." And until then, I’ll make sure that my family and I have the resources to survive.

Enterprises do exactly the same thing. They would love, I am sure many of them would, to see a more open, transparent, market – banking, financial services, etc. But until they see that and understand that it’s stable and permanent, they’re going to spend a lot of time protecting themselves. And that, from an economic standpoint, is very inefficient. It’s a waste of resources compared to "normal market economies." From the individual standpoint, it’s completely understandable and rational, it’s the smart thing to do. So we’re still in this trap right now in Russia. It will require a longer period of stability before you begin to see people shift away from these self-protecting modes of behavior.

RJ: Can you just give some indication and explanation of the scale of the trade surplus Russia saw last year and what that meant?

CG: The absolutely remarkable fact about the Russian economy is that despite apparent prosperity in certain statistical areas, we’re dealing with something that is quite unusual internationally, and perhaps unprecedented, for the simple reason that in the year 2000 the current account surplus was $46 billion, or 18.5 percent, if we translate Russian GDP at the market exchange rate into dollars.

This is a staggering amount, and has to be understood relative to certain other countries. In the 1980s Japan ran what was considered to be a huge current account surplus, so large that it was occupying the minds of economists and policy-makers internationally. How big was it? It was about 4 percent of Japan’s GDP. Russia’s was 18.5 percent.

Today there is no ordinary, normal-sized economy that has anywhere close to Russia’s current account surplus relative to GDP. So it’s like an order of magnitude bigger than other countries. And to think that a country that runs a current account surplus that large is toying with the idea of asking of asking for debt relief, that debt payments are a problem, says something very stark about the Russian economy. It is very, very unusual.

RJ: Does that say something about the government or the economy?

CG: Well, I think it has to do with the Russian economy. The government is suffering from the constraints of having to maintain an economy, such a large part of which is not creating wealth. It is not even neutral in this regard, but it is actually consuming or devouring wealth, rather than producing new wealth. And this is not the fault of the current Russian government, this is the legacy of 60-70 years of Soviet rule, but it is clearly something the current government has to deal with and won’t escape from for not just years but decades to come.

RJ: What’s your prediction then in terms of Russian growth.? Can it be sustained at 4-5 percent, or will it taper off?

CG: The numbers are difficult to interpret. Even of the last two years, we need to ask, what is the quality of this growth? And some of what is being recorded as GDP growth is in fact the revival of non-competitive products being produced by industrial enterprises. This is a fact. I know this. And most enterprise directors who are honest can tell you they’re simply reviving some of the things that a market would not qualify as truly marketable.

So there’s the question of the quality, which also affects the level of growth – what’s the meaning of 2 percent versus 5 percent then?

I do think that given there has been so much looting – just pure looting – taking wealth that has been produced by the economy, because the Russian economy does produce wealth, most of it in its natural resources sector, but it is in huge amounts. If some of that can stay and be reinvested, be used within Russia, then you can get substantial benefits from that. So there’s a lot to be achieved just by doing that alone.

The second way to achieve growth without creating new sources of production of wealth is by more efficient use of what you have. For instance, just being able to have enterprise managers concentrate on their businesses as opposed to concentrating on protecting themselves from organized crime or corrupt bureaucrats in the government, this pays off in terms of wealth that is actually usable for the standards of living of the population.

And given that Russia was in such abysmal shape, had reached such an abysmally low point by the end of the 1990s, there’s a good deal to be gained in that area as well.

And so it’s difficult to say how long, perhaps as many as four to five years, perhaps even more, you can continue to be more efficient in using what you have. But at some point you run out. These opportunities exhaust themselves and you have to be creating new wealth. That’s where Russia’s real dilemma is, that’s where Russia’s real challenge is, to find new sources of wealth creation, through new industries, new products, new businesses, new services, and reallocating what you have to create new wealth.

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