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The debate on economic growth in Russia usually revolves around short-term issues, such as whether the recession has ended, and whether GDP will grow by more than 2 percent in 2017. These questions are of course important, but of far greater significance are the political and economic changes that could substantially increase the long-term rate of Russia’s economic growth.
If in the coming decades we plan to catch up with developed countries, the debate over whether the Russian economy will grow by 1 or 2 percent this year is totally irrelevant. Russia’s per capita income is about a third of what it is in the United States. To halve that gap during the next twenty-five years, Russia’s economic growth would have to outpace that of the United States by 3 percentage points each year. If U.S. per capita income grows by 1.5 percent annually (as the International Monetary Fund predicts it will), Russia’s would have to grow by 4.5 percent. And to catch up with the United States in twenty-five years’ time, Russia’s per capita income would have to grow by 6 percent annually, about the same as China’s current growth rate.
Long-term economic growth depends on four fundamental factors that change slowly (if at all): human capital, economic and political institutions, geography, and culture (defined as the set of values, attitudes, preferences, and social norms).
The causal relationships between these four factors work in all directions. If reforms can promote international competitiveness of human capital, accountability and transparency in the political system, improved protection of private property, independence and effectiveness of the judiciary, increased trust within the society and toward the state, and the rejection of corruption, then any of these reforms will accelerate economic growth, both directly and through other fundamental factors.
The interaction of these factors can create a vicious circle or at least path dependence. For instance, if ordinary people distrust business, believing that it only cares about its own short-term interests at the expense of those of society at large, they may come to approve of officials extorting bribes from businesses. That, in turn, disincentivizes entrepreneurs from investing in their reputation: no one trusts them anyway. Yet a different stable equilibrium is possible as well; in this equilibrium entrepreneurs behave responsibly and enjoy the trust of the public, who demand that officials protect their property rights.
Since both of these equilibriums are stable, transitioning from one to the other is not easy. So, as the Russian economist Alexander Auzan has noted, one may consider crossing the abyss in two jumps—through designing so-called “transitional institutions.”
The concept of transitional institutions was first introduced by the Chinese economist Yingyi Qian in his 1999 paper “The Institutional Foundations of China’s Market Transition.” Qian showed how Chinese reformers refrained from immediately building first-best institutions, preferring to start with intermediate, or “transitional,” institutions.
To understand how and why these institutions worked in China, let us consider the example of dual-track liberalization in agriculture (and industry). The main idea was that the enterprises would as before have to fulfill a plan, delivering a specified quota of products at regulated prices, but could sell the surplus (production in excess of the quota) at market prices. In this way, China managed to avoid the collapse of the command economy—planned deliveries continued—while creating market incentives, since marginal units of production were valued at market prices.
A precondition for such a system is the confidence of enterprises that the state will fulfill its commitments, guaranteeing both the enterprise’s right to sell its surplus at market prices and suppliers’ obligations to deliver the specified quantity of inputs at regulated prices. If the state reneges on the first condition—for example, if the state takes over all the output (including that in excess of plan quotas) at the regulated price—the marginal market incentives break down. If the second condition is not observed, the enterprise understands that it must scramble for finding its inputs—buying them in the market or through barter, and will try to make some extra money by selling even its basic quota at market prices.
The transitional institutions cannot therefore be effective unless the economic agents are confident in the state’s ability to commit. To convince economic agents that the rules of the game do not depend on the discretion of a particular leader, Deng Xiaoping and his successors have designed a sophisticated system in which the Chinese Communist Party’s leadership rotated and meritocratic principles drove promotion within the party and state hierarchy. After Mao, Chinese leadership has been rotated every ten years. China closely followed the “seven up, eight down” principle (sixty-seven-year-old leaders can be nominated into the Standing Committee, but the sixty-eight-year-old ones could not). Moreover, the Beijing vacancies have been filled by regional leaders who have outperformed their peers in terms of economic development.
Transitional institutions require political institutions focusing on long-term development—which necessarily include checks and balances. For various reasons, Russian public opinion is not fully committed to the view that such institutions can be built within a democratic political system. On the other hand, the European Bank for Reconstruction and Development (EBRD) has always been certain that democracy and political competition are not only valuable in themselves, but also help to build a sustainable market economy.
Daron Acemoglu and James A. Robinson’s bestseller Why Nations Fail provides ample empirical evidence that democracy promotes economic growth. Democracy protects investors from expropriation and from arbitrary changes to the rules of the game better than dictatorships do, therefore resulting in faster economic growth.
Democracy—and democracy in particular—is perfectly compatible with a market economy. The stereotype that inequality in a market economy necessarily leads to the rise of populism stems from a misunderstanding of the nature of different types of inequality. Inequality, like equality, can be fair or unfair. When those who work hard and those who do not receive the same compensation, that is unfair equality. When success comes through connections and bribery rather than through talent and industriousness, that is unfair inequality. In a recent publication, I described how residents in transition economies reject market reforms when inequality is unfair and support market reforms when inequality is fair.
This is why the EBRD considers inclusion (defined as equality of opportunity) as one of its key priorities. If market reforms bring about unequal opportunities, those reforms are rightly considered unfair and are rejected by the majority of voters. Developing and advancing such reforms is futile and even counterproductive, as they undermine trust in market economy altogether. On the other hand, if democratic institutions make the government accountable to the majority of voters, and the market economy increases the well-being of all, not just of a small elite, that is a recipe for politically sustainable economic growth.
One of the risks involved in creating transitional institutions is the emergence of coalitions of incumbents with no interest in facing competition from new entrants. Such pro-status-quo interest groups impede the transition to optimal institutions, resulting in stagnation. That is the main mechanism of the so-called middle-income trap. Certainly, the middle-income trap is not universal—many countries manage to avoid it. For example, in South Korea, the 1998 crisis has destroyed the political legitimacy of the chaebol-based status quo—and facilitated transition to the post-industrial competitive and innovative knowledge-based economy.
Alexander Auzan is right in arguing that institutions are not built in a day. This is true of both optimal and transitional institutions—as the latter require the existence of strong political institutions. It is also true for other fundamental factors driving economic growth, such as human capital and culture. But the longer the journey, the sooner it should start.
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