Krueger, Gary

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Macalester InternationalVolume 7 Globalization and Economic Space Article 23February 2009Response to PopovGary KruegerMacalester CollegeFollow this and additional works at: http://digitalcommons.macalester.edu/macintlThis Response is brought to you for free and open access by the Institute for Global Citizenship at DigitalCommons@Macalester College. It has beenaccepted for inclusion in Macalester International by an authorized administrator of DigitalCommons@Macalester College. For more information,please contact scholarpub@macalester.edu.Recommended CitationKrueger, Gary (2009) "Response to Popov," Macalester International: Vol. 7, Article 23.Available at: http://digitalcommons.macalester.edu/macintl/vol7/iss1/23ResponseGary KruegerMy response reviews and extends slightly the work of Dr. VladimirPopov on Russia’s unique transition to market economy. Using Russiaas an example, my hope is also to shed light on important areas of eco-nomics in general, especially as they relate to the social and legal infra-structures that form the basis of what I term “pathological” economicsystems.1 At the outset, it is important to note that I have no fundamen-tal disagreements with the conclusions and basic viewpoints of Dr.Popov. As is typical of academics, however, I do not necessarily concurwith the course he pursued to reach those conclusions. The followingrepresents an alternative and, hopefully, illuminating path to arrive ata somewhat different diagnosis of Russian economic maladies, as wellas a similar, but not identical, prescription.Dr. Popov begins by assessing the initial conditions inherited by thetransition countries of the former Soviet Union, Eastern Europe, andSoutheast Asia, and finding that the countries of the former SovietUnion tended to have the worst performance, measured in terms oftotal decline in output, among the transition economies. He also mea-sures, and then assesses, the role of the legacies of central planning inaffecting variations in transition outcomes. Popov then makes thenoteworthy conclusion that the institutional structure of transitioneconomies appears better able to predict transition performance thanthe rate of liberalization.2 This important finding elevates the debatefrom the level of an overly simplistic and unproductive argument con-cerning the merits, or lack thereof, of shock therapy versus some unde-fined gradual alternative. Not only is this a valuable contribution, butthe author also makes his point directly and clearly.In the second part of his essay, Popov links poor Russian economicperformance during the transition to an inability to increase exports,pointing out that export-led growth — as demonstrated by the transi-tion economies of China and Vietnam and earlier by the marketeconomies of Japan, Korea, and other Asian economies — can place acountry on the road to sustainable development. Additionally, Popovidentifies the key role of exchange-rate policy, and explains how Rus-sia’s decision to maintain its exchange rate at levels that were abovepurchasing power parity was a serious policy mistake. Also, he cites271the failure of the Yeltsin government to support key sectors of theeconomy, especially aerospace and energy.II. Analysis and Suggested ExtensionThe evidence for the main conclusion—that the rate of liberalization isless important than the institutional structure shepherding the moveaway from central planning — is, however, a bit suspect. The leadingwitness is figure 3 which plots the decline in the share of governmentrevenues from 1989 – 91 to 1993 – 96 as a variable that explains thedecline in output from 1989 to 1996. Figure 3 shows that countries withlarger declines in the shares of government spending as a percentageof GNP tended to have larger declines in total output from 1990 to1996. Of course, Popov uses this variable as a proxy for the institu-tional strength in these countries, but it is a problematic variable to usein a regression. As government spending was a large share of totalproduction in centrally planned economies, the fact that declines ingovernment spending correlate with declines in GNP is not altogetherstartling. The reason is, of course, seen directly from basic macroeco-nomics as GNP = C + I + G + X – M, where GNP is gross nationalproduct, C is aggregate consumption, I is domestic investment, G isgovernment spending, and X – M is net exports (crudely put as tradebalance). In other words, a decline in one of the components of anaggregate statistic correlates with the decline in that statistic.3Popov’s other primary finding is that Russian policy-makers failedbecause they did not strategically target investment to export sectors ofthe economy, and they pursued a policy of an overvalued exchangerate. The conclusion — prescription really — is that export-led growth,which was successfully implemented in Asia, is the best approach foralleviating Russia’s transition depression. The evidence that Asiangrowth was based on exports is, however, not conclusive.For much of Japan’s post-war history, Japan had either no surpluson current account or only a small surplus. Not until the early to mid-1980s did Japan begin to run significant surpluses, by which time ithad already achieved its stature as a world economic leader. More-over, exports as a share of GNP in Japan in 1980 were 14 percent, whilein 1994 they had fallen to only 9 percent, according to the World BankDevelopment Report of 1996. These percentages are low enough tosuggest that most economic activity in Japan was domestic, althoughat the margin, exports were highly beneficial. China initially (after theMacalester International Vol. 7272implementation of Dengism in 1979) appeared not to rely on exportsbut, rather, on increased productivity in agriculture and rural enter-prises. Only in the later 1980s and early 1990s do we see the large sur-pluses on external account. In sum, I believe it is not clear that (a)Asian economies were exceptionally dependent upon exports as asource of growth or (b) this prescription is suitable for a large continen-tal, resource-rich country such as Russia.III. An Alternative DiagnosisIn order to better understand the situation in Russia, we need somebasic macroeconomics, or just about everything you might need toknow if you worked for the IMF or World Bank in the Applied MacroDivision.4 An analysis of the basic components of GNP, and the associ-ated accounting rule, provide some insight into Russia’s transitionrecession. More formally, these components can be expressed as:Y = C + I + G + X – M (1)Y = GNP (gross national product)C = consumption by private citizens of goods and servicesI = domestic investment (purchases of durable goods — plants, equip-ment, etc.)G = spending by government on goods and services (excludes transferpayments to pensioners, etc.)X = exports (sales of goods and services abroad)M = imports (purchases of goods and services from abroad)X – M = balance on current account, also called “external balance”Y = C + S + T (2) (Accounting Rule)Y, C as defined aboveS = personal savings by individuals plus retained earnings by busi-nessesT = taxes collected by governmentEquation 2 is referred to as an accounting rule because all income musteither be spent, saved, or taxed.Gary Krueger273Equations (1) and (2) can be easily shown to imply the following rela-tionships:(S – I) + (T – G) = (X – M) (3)S – I is the balance between savings and investment, or the private sec-tor balance. T – G is the balance between taxes and government spend-ing, or the public sector balance. The private sector surplus or deficitwill influence the external balance, as will the public sector surplus ordeficit. Countries with deficit on current account may have them fornumerous reasons. One may be that the public sector is imbalanced(G>>T); another is that I>>S (where “>>” is read as strictly greaterthan).Finally, we should note the following identity from internationalbalance of payments accounting:External balance on = opposite balance + changes in holdingscurrent account on capital account of reserve currenciesCountries with surplus on current account run deficits on capitalaccount; that is, they import more assets from abroad than they export,and vice versa. Since 1981, the United States has run current accountdeficit and capital account surplus: we sell more assets (T-bills, stocks,corporate bonds, land) to foreigners than we buy from abroad. In otherwords, the United States is a net debtor, while Japan is in the exactopposite position, a net creditor.The situation in Russia throughout the transition has been unique:declines in GNP of upwards of 50 percent since 1990, accompanied bya decidedly negative public sector balance on the order of – 8 percentof GNP, a very large percentage.5 The large public sector imbalancewould suggest that the current account also ought to be negative, yetthe Russian economy has consistently run surpluses on currentaccount since 1992. Obviously, the only source of surplus on currentaccount must be very large surpluses in the private sector. In otherwords, Russian savings must be significantly larger (by approximately10 percent or so) than investment.Recent data from the Organization for Economic Cooperation andDevelopment (OECD) shows that investment declined by 75 percentfrom 1990 to 1996, considerably more than the total decline in outputof roughly 40 percent.6 Admittedly, the figure from 1990 representsMacalester International Vol. 7274investment levels that were excessive by international standards; nev-ertheless, the declines in investment appear to have “led” declines inGNP. The question then is: Why are investment levels so low in Rus-sia?Popov’s figure 3 may not be very useful for causal inference. But ifwe turn the causality around and posit that the decline in output led tothe decline in government spending (as governments facing decliningoutput and tax receipts were forced to cut back expenditures) and,additionally, if we examine the Russian government’s peculiarresponse to the situation, we have insight into the large decline ininvestment.Local and federal government agencies in Russia issue budgetaryauthority; that is, they write a contract with a private or semiprivateorganization for some good or service based on anticipated budgetrevenue. During the budget period, it is invariably discovered that taxrevenues are lower than expected. Lower tax revenues risk upsettingfiscal balance (the relationship between tax receipts and governmentexpenditures), which threatens to re-ignite high inflation.7 In order toreduce the risk of inflation, government agencies delay payment ofcontractual obligations for months or sometimes years at a time. Thus,the government reneges on its own declared budgetary (presumably)contractual obligations. Throughout history, there have been instancesof government default on securities, and there have been hyperinfla-tions — which amounts to the same thing — but rarely has there beensystematic and sustained contractual recklessness comparable to thatdemonstrated by the current central government in Russia.Why is the emphasis on contracts so important and how does itrelate to investment? The late Mancur Olson, in analyzing economicdevelopment, asked the question: If almost everyone now has a marketeconomy, and if markets are so good, then why isn’t everyonewealthy? His inquiry led him to consider the institutional frameworkthat supports market transactions. Most interestingly, he consideredthe institutional “requirements” necessary for supporting two types oftransactions. Type I transactions are those in which the “quid”(money) is exchanged simultaneously for the “quo.” Examples of TypeI transactions are everyday purchases of groceries and beer at thekiosk, or even drug deals on the west side of Chicago. The latter exam-ple illustrates the fact that the institutional infrastructure necessary tosupport Type I transactions may be very meager (i.e., total lawless-ness); furthermore, highly risky Type I transactions, in which both par-Gary Krueger275ties desire to exchange, are very common throughout the world. Thekey to Type I transactions is that they do not require external, or thirdparty, enforcement. Because they are, in principle, self-enforcing, it is arelatively simple matter to ensure that the quid and the quo are bothgenuine and delivered. Equally important, because they are simplyreallocating preexisting production, they are not wealth creating,although they are pareto improving.Consider now an alternative type of transaction, the Type II, inwhich the exchange of the quid and the receipt of the quo are sepa-rated in time—specifically, a transaction in which one receives the quoprior to paying the quid. Generally, the quo may be paid for over timeas, for example, when one buys a house or a car (in developed marketeconomies, that is). The key to these Type II transactions is that theyare relatively more complex to effect and generally are based on veryexplicit written or oral contracts/agreements.Additionally, Type II transactions are capable of generating wealth(in other words, a “stream” of additional income that lasts for consid-erable periods of time). An example would be college loans, of which Iam a past expert. The loan allows the recipient to avoid a pay-as-you-go approach to getting an academic degree, thereby reducing the totaltime necessary to get that degree. This permits more years of addi-tional earning power at the educationally augmented level, hence cre-ating wealth.Mancur Olson’s insight into understanding problems of develop-ment, particularly those plaguing the Former Soviet Union (FSU), isbased upon consideration of the institutional infrastructure necessaryto support Type II — wealth-creating — transactions. The key to effect-ing Type II transactions is third-party enforcement, especially as itrelates to ensuring that the recipient of the quo pays back the quid. It ispossible, I believe, to generally classify economic systems, oreconomies in particular, based upon the dominant type of enforcementof contractual arrangements. In the United States, we seem to prefercourts stuffed with lawyers. In Japan, there are, of course, lawyers, butthere is also a premium placed on trust inherent in long-standing rela-tionships.In the current Russian economy, there is considerable competitionfor the rights to enforce contracts — especially within the mafia.Although economists generally regard competition as a good thing,when it comes to the right to enforce contracts, it is better to have amonopolist—the government. However, the Russian government is soMacalester International Vol. 7276weak, partly because of its own actions and partly because of theupheavals during the past decade, that it lacks the ability to secure amonopoly position in contract enforcement. When contractual rightsare impossible to guarantee and enforce, potential lenders — that is,savers—hide their capital either under the proverbial mattress (one ofmy Russian friends has $20,000 in his garage wall) or send it abroad.As a result, very few wealth-creating Type II transactions are takingplace in Russia, although lots of pareto-improving Type I transactionsare happening.One indicator of the severity of the current situation in Russia iscontained in the preceding Table, which provides data on nonfinancialcommercial credit as a percentage of GNP in Russia. If lots of Type IItransactions were occurring, we would expect a sizeable amount ofcredit to the private sector as a percent of GDP. But the figures in theTable reveal that Russia ranked far below other transition economiesin 1996, and my guess is that figures for 1998 will show further reduc-tions. Of course, it is possible to have too much of a good thing, andthe high percentages of credit relative to GDP in Bulgaria and theCzech Republic were inflationary. But the levels of credit in Russiawere undeniably well below the more “normal” levels of Poland andHungary.IV. ConclusionFinally, I want to repeat that my analysis and that of Dr. Popov lead usto the same basic conclusions. In short, Russia’s transition recessionwas exacerbated by government policies — specifically, its exchange-Gary Krueger277Table 1 Commercial Bank Credit in Transition Economies:Credit to the Nonfinancial Sector as Percent of GDP1993 1994 1995 1996Russian Federation 20.4 19.6 12.0 10.4Poland 21.3 19.8 19.7 22.1Hungary 28.4 26.5 23.0 22.9Czech Republic 73.1 72.9 63.8 61.1Slovakia 71.5 60.4 59.2 62.4Romania 24.4 19.0 22.7 24.6Slovenia 22.2 22.9 27.5 28.7Bulgaria 67.8 51.0 41.3 69.5Source: OECD Economic Surveys (1997), p. 92.rate policy and fiscal irresponsibility. And Russian institutions haveproved themselves woefully inadequate to sustain a well-functioningmarket economy. In six years of transition, the Russian political andeconomic elite have failed to create institutions that support Olson’sType II transactions. The almost total absence of capital markets hashad disastrous consequences for what remains of Russian industry.Firms that make and sell durable goods find that their potential cus-tomers can only purchase durable products from cash on hand, whilethe funds to restructure production in durable-goods industries (andhence increase Russian competitiveness) are virtually unavailable.Because Russia is a market economy without a capital market, it hasbecome a unique economic subspecies: a noncapitalist market econ-omy.Notes1. The numerous works of the late Mancur Olson, especially on the relationship betweenforms of government and economic prosperity, are enlightening.2. This conclusion appears, however, to assume that these countries will indeed liberal-ize and not revert to central planning or some other statist policies.3. In addition, these data should also be adjusted for differences in starting points for thetransition; after all Poland and other Central European countries began the transitionroughly two to three years before the countries of the former Soviet Union.4. The following material represents the first time since conducting a review session as ateaching assistant at the University of Wisconsin-Madison in 1984 that I, an appliedmicro-economist, have performed public macroeconomics!5. For example, at the peak of the U.S. government deficit in the late 1980s, the publicsector deficit was on the order of –3 percent of GNP.6. There is some controversy in measuring the decline in output during Russia’s transi-tion. Original Goskomstat data suggest a decline of 50 percent from 1990 to 1996, while arecent revision in their calculations places the decline in total output at 37 percent. Ofcourse, none of these estimates captures the large share of production taking place in theunderground economy.7. In the early phase of the transition (1992 – 94), Russian inflation was typically in therange of 20–40 percent per month!BibliographyLincoln, Edward. Japan: Facing Economic Maturity. Washington, D.C.: Brookings, 1988.McQuire, Martin, and Mancur Olson. “The Economics of Autocracy and Majority Rule.”Journal of Economic Literature (March 1996): 72–96.OECD Economic Surveys. Russian Federation. Paris: OECD, 1997.Olson, Mancur. “Big Bills Left on the Sidewalk: Why Some Nations Are Rich and OthersAre Poor.” Journal of Economic Perspectives 10, no. 2 (Spring 1996): 3–24.Macalester International Vol. 7278

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