Russia's economic crisis could have been avoided

THE Russian government and people, awash with money, were convinced their economy was invulnerable to the world financial crisis. By September, Russia's gold reserves stood at $581 billion. The federal budget seemed strong, salaries high, economic reforms successful and government investments wise. In hindsight, it was all too noticeably "Potemkin" and vulnerable. When foreign markets crashed and oil prices fell, Russia's financial standing changed overnight.

When President Dmitry Medvedev told the world that "Russia has not yet been caught in this whirlpool and has the opportunity to escape it," close observers winced. Rory MacFarquhar, managing director of Goldman Sachs in Moscow, told The Wall Street Journal the truth about the Kremlin leaders. "They made the mistake of confusing high oil prices with the genius of their economic management," he said.

The economic reforms implemented by Putin during the eight years of his presidency were well designed. The management of the economy was not. Where did Putin and his team go wrong?

While the Kremlin and Duma created the infrastructure for a striving diversified economy, they failed to let businesses strive and the economy diversify. Putin's government modernized Russia's banking system and alleviated some corruption. He ensured the reduction of the Communists' seats in the Russian parliament from 24 percent in 2000 to 8 percent in 2008. His United Russia party's majority in the parliament allowed Putin to push forward progressive reforms and introduce Russians to land ownership and the flat tax. Combined with the functioning banking infrastructure, the latter changes developed into a credit system — the first one in modern Russian history. The winds were blowing the Kremlin's way. Rising oil prices allowed Russia to pay off its foreign debts and to save $750 billion of surplus. But all stories, even good ones, must end.

Russia's crisis has its origins in its investment strategy. In February 2008, the Stabilization Fund was split into a Reserve Fund ($125 billion), which was invested abroad in low-yield securities, and the National Welfare Fund ($32 billion), which was invested mainly into Russia's energy giants Gazprom and Rosneft. As of mid-July, the price for a barrel of oil peaked at $147, and Russian buyers held $75 billion worth of U.S. agency securities. The National Welfare Fund did well and stood at nearly $49 billion on Oct. 1, after months of solid growth in the world's energy prices.

Fast-forward several weeks. The billions in U.S. securities turned out to be a rotten investment. Oil prices fell by nearly 60 percent, bringing down the market value of Russia's energy giants. Modernization of the industry's infrastructure heavily depended on foreign investments. These started to leave the country right after military actions in Georgia began. They nearly disappeared with the financial crisis.

So, eight years after President Boris Yeltsin gave up the presidential suite, Russian economic legislation had matured, but the economy hadn't. Russia doesn't have much to show for its meteoritic economic rise and fall, unless you count Moscow's empty nightclubs that used to charge $40,000 for table service. Russian shipping companies still don't have a paved road to drive on from Moscow to Vladivostok, small businesses struggle to borrow money at annual percentage rates of 15 to 20, scientists choose to work in Europe and America because of access to better equipped laboratories and universities, and Russian troops still wear belts with big Soviet stars on the front and fire Kalashnikov machine guns that were generously left behind all across the Former Soviet Empire.

Now that oil revenue is low and Western banks' securities are next to worthless, one must ask: Could Russia have avoided the impact of the crisis? The answer is simple: Yes. Nearly one trillion U.S. dollars is real money, and it could have bought a lot of vital goods.

Missed Opportunities

Science and innovation. Israel, nervously tucked away in a region of Islamic fascism, keeps spitting out almost unbelievable high-tech inventions, selling them to the West and the East, then selling the companies, establishing new companies, inventing more. And it goes on. Meanwhile, university buildings across Russia are falling apart. While professors' enthusiasm is enough to teach Pushkin and Tchaikovsky to Russian students, it falls short of giving access to high-tech equipment, genetic research labs and nanotechnologies.

In the past decade Russians could afford anything they desired. Aside from Elton John, they could have brought to Moscow Harvard business professors, Cornell agricultural scientists and Microsoft's managers. Instead, Russian government officials traded in their rusty Volgas for bulletproof, shiny Mercedes.

Entrepreneurship and leadership. These are alien concepts for an average Russian. If it is easy to imagine that out of 100 American students, 80 wish to have their own business one day, the same can be said about perhaps 10 percent of Russian kids. Laziness and ineptitude are not the reasons. It is just that Russians have never been coached that way. Russia is a well-educated nation. It has a 99.4 percent literacy rate. However, since early childhood, an average Russian child is groomed for a "job." Entrepreneurial instincts are often seen as an oddity. And if an American child hears daily confirmations that "Yes, he can!" a Russian student hears exactly the opposite, from his parents, teachers and professors.

Beginning eight years ago, Russia's oligarchs should have been encouraged not only to pay taxes on time while acquiring British soccer teams and large yachts in the Caribbean, but also to help encourage entrepreneurship in their own country. The new Skolkovo School of Management has gained national attention and Putin's support, but perhaps too late. According to Ruban Vardanian, an oligarch and founder of the school, it "is supposed to have everything in place by 2012... . Russia's future lies in its people, not its oil and gas."

Small business loans. Many small businesses don't survive the first year of their lives. Loans to small businesses are a risky investment. But would Russian candy makers, farmers, leather goods manufacturers, and graphic designers have been riskier than, let's say, Washington Mutual? No.

Those Russians who started their own businesses applauded the flat tax. Russian business owners can choose between a 6-percent flat tax on gross revenue and an 8-percent flat tax on net profit. At a flat rate of 13 percent, the income tax is the same for everyone. But loans are hard to get. The difficulties of obtaining low-interest loans pushed Russian entrepreneurs into illegal activities. They have been paying their taxes, but they have not been creating jobs. It costs too much to legally hire a Russian, and the availability of illegal immigrants from the former Soviet republics is way too tempting. So while many small businesses have grown, they haven't accomplished one of their major destinies for the nation: job creation.

Infrastructure. Today Russia is probably the only developed country that isn't inner-connected by a freeway system. Never mind having a system; there isn't even a freeway. The Russian government modernized the railroads and built the highways in major cities. But the cities across the country remain disconnected and the villages forgotten. Railroads are the remainder and reminder of the centralized economy. Rails ignore the interests of small businessmen and bypass small towns.

Recently, I was in Williams, Ariz., a small town on the way to the Grand Canyon. But think of all the dollars left by the tourists in this town for gas, sodas, post cards, and traffic tickets. Imagine if the train station in Las Vegas connected you with the Grand Canyon without an option of a highway. Would Williams survive? Would an American entrepreneur use a horse to deliver the touristy goods to the remote destination?

The United States can be blamed for many things, including long-term neglect of Russian relations after the collapse of the USSR. But America can't really be blamed for Russia's current economic problems. Seven hundred-fifty billion greenbacks in the Russian vaults as of earlier this year was enough to hire professors, build laboratories, give loans to small businesses, and pave freeways. The Russian economy would have been diversified and not nearly as dependent on the price of oil. That chance is gone. So too are the savings. The good news is that world leaders appear to be united in resolving the crisis. Eventually, the world economy will certainly rebound and there will be another chance. When that day comes, let's hope that whoever is sitting in the Kremlin knows his history and makes dramatically different investment decisions.

Yuri Mamchur of Seattle is the founder and editor of Russia Blog and director of Discovery Institute's Real Russia Project. He is also executive director of The World Russia Forum.