#8 - JRL 7266
OPINION: The Principal-Agent Problem Of Russian Politics
Contributed by Alexei Zabotkine, Chief Economist, United Financial Group

MOSCOW, July 25 /Prime-TASS/ -- In the past three weeks there was no scarcity of theories on the nature of the conflict between Mr Khodorkovsky and the Kremlin and possible scenarios for future developments in the near-term.

However, we would like to use the current pause in the stream of day-to-day developments to take a step back and look at the affair around Yukos from a more macro and longer-term perspective. The analytical framework of the so-called "principal-agent problem" may be particularly useful for these purposes.

In economic theory the principal-agent problem applies to a class of asymmetric contracts between two parties in which one party -- the agent -- acts on behalf of the other -- the principal -- on the basis of certain incentive. The core of the problem stems from the fact that the agent tends to be in a position to benefit from reneging on such a contract. It may be rephrased as a more commonly known formula -- the interests of the principal and the agent are not strictly aligned.

We believe that what on the surface looks like an almost personal stand-off between Mr Khodorkovsky, Russia's richest person, and the Kremlin, highlights a much deeper and more fundamental divide between two large groups of interests, which can be seen as two political classes.

The first one is the old political class of apparatchiks (this encompasses not only the civil service but also the law enforcement and national security agencies and the military), which has been inherited from the Soviet state and has sustained itself remarkably well since the dissolution of the Soviet Union. The other is commonly (and narrowly) referred to as the "oligarchs," but a more appropriate term would be "private sector interests." For the purposes of this analysis let's call it the new political class.

After 15 years of transition -- if we start from the creation of first Cooperatives in 1988 -- the bulk of Russia's assets are in the hands of the new political class. At the same time, it is the old political class which retains the monopoly on policymaking. The former, thus, may be seen as the "principal," owning most of the country, while the latter is the "agent," running it. The conflict between the two, therefore, is almost predetermined.

The problem is exacerbated not only by the fact that the agent has its own agenda, but -- as the Yukos/Khodorkovsky affair clearly highlights -- it is resisting the greater involvement of the principal in running the enterprise that is the Russian Federation. To make things even worse there is no supreme arbiter, who could make the agent abide by the contract -- which in this case is Jean-Jacques Rousseau's "social contract."

By this logic we conclude that, regardless of the outcome of the Yukos/Khodorkovsky conflict with the state (and, probably, a compromise of some sort will be carved out after all), the tension between the new and old political classes will remain. And it will sustain the uncertainty of Russia's political landscape over a prolonged period of time, in the worst case through the whole of President Putin's second term.

Admittedly, an important question to be answered in this respect is whether the new political class would do a better job running Russia than the old one. Indeed, Russia experienced a private sector-dominated "oligarchic" government in 1996-7 and the results were far from satisfactory. Thus, it comes as no surprise that many observers are sceptical when debating the election of new private sector candidates to executive posts, and some are even appreciative of the Kremlin's counterattack on Mr Khodorkovsky's political ambitions. Nevertheless, we are prepared to grant the benefit of the doubt to the "principal" class. Here is why.

It is true that the track record of Russian big business and its leaders, commonly known as the "oligarchs," is far from flawless. In the mid- to late-1990s they employed questionable (sometimes even brutal) business practices and resorted to value-destroying rent seeking, which was the primary cause of Russia's decade-long "transitional depression."

However, the same fully applies to another infamous centre of power in Russia. Commonly dubbed the "state mafia," the bureaucratic machine inherited from the soviet era has since that time become an even uglier beast. Similarly unacceptable practices and rent seeking had become a trademark of the civil service even prior to the fall of the Soviet Union.

What is different though, is that the private sector has increasingly changed its spots during the last four to five years, having switched from a rent-seeking approach to a value-maximising one. At the same time, the state apparatus has barely changed its ways, having so far efficiently repelled all attempts by Mr Putin's reformers to re-engineer the public service.

Our confidence in Mr Putin's ability to combat the forces behind the old political class -- i.e. the state apparatus -- is limited. His declaration of administrative reform as a priority made in his State Of the Nation Address in April 2002 has almost fully run into the sand. The attack on high-ranking corrupt police officers -- the case of "werewolves from the police" -- is welcome, but we will judge the results only when we see them. In general, we have serious doubts about feasibility of the reform of the state apparatus from within.

At the same time, the Russian private sector has convincingly proved its ability in the last few years to act as an agent of change in the Russian economy. We believe that the expertise and resources (above all, human capital) which the private sector -- and, in particular, leading corporations -- have accumulated in this capacity as agents of change will be useful for imposing a long-desired change upon the state machine.

All in all, at the very least we see this new political class as being a lesser evil compared with the existing amalgam of apparatchiks and law enforcement officers. And in the best case, this class may offer Russian citizens the quickest way to a proper civil society. A separate question is whether Russian citizens at large are ready for such a society… we are rather tempted to answer "not yet."

And the real significance of the clash between Yukos shareholders and the state machine is not its impact on short-term market sentiment. Rather, it is the implications it bears for the outlook of Mr Putin's second presidential term as regards Russia's structural adjustment and investment climate. A month ago the outlook was bright. Today, we have to admit, the jury is out.