Engineering Corruption - The Promise of Privatization

Around 1991, a few enterprising political reformers in newly-independent Russia began the process of separating an entire nation from its money, neatly depositing the gains tax-free into offshore bank accounts. With high hopes from the West, they oversaw the rapid implementation of the same economic principles that organized all successful western economies, and yet would inexplicably result in the country’s total financial collapse five years later.

Privatization laid the groundwork for the codependency between powerful titans of industry and political officials that the country is laboring under to this day. It undermined the legitimacy of its government domestically, making corruption the second most pressing concern among Russian citizens, trailing widespread drug abuse by only four points.

As we continue to analyze the 2016 presidential election and its impact on our politics, one thing is becoming clear: the relationship between money and power, and how we view its role in our government, is at a critical juncture. The push to privatize public resources has been reinvigorated, and Russia provides a fascinating case study of the structural changes that occur when the line between business and governance is obliterated. The reforms implemented during the Gorbachev and Yeltsin administrations, though well intentioned, created a perfect storm that derailed the needed efforts toward economic liberalization, and instead sent Russia on a path toward a state of gangster capitalism.

  

After the Fall

Mikhail Gorbachev's economic and political reforms, implemented for years prior to the breakup of the Soviet Union, would ultimately trigger his political demise, and hasten the collapse of a system he knew to be unsustainable. The election of Yeltsin and subsequent dissolution of the union hastened more radical reform efforts led by Russian economists and politicians, western economic advisers, and a class of robber barons who exploited the quickly shifting environment and uncertainty for their own financial gain.

In Russia, the roadmap for the conversion to a market economy hinged on the rapid privatization of state assets, from trucks and textile factories to oil fields, and everything in between. “Shock therapy” was aptly named; the goal was to destroy the centrally planned economy, quickly implement neoliberal economic reforms, and let the new market sort it out as soon as possible.

Russian economists Anatoly Chubais and Yegor Gaidar, the plan’s principal architects, ignored the early indicators that wealth was escaping the country by the billions, prioritizing the transfer of property to private ownership. Hoping to speed up the turbulent transition, they looked the other way as evidence mounted that opportunists were fleecing the country of its most valuable assets. They delayed the removal of price controls for far too long, while continuing to print excess money, exacerbating the so-called ‘ruble overhang’. Controls had kept the prices artificially low, while monetary circulation was unnecessarily high, and the hyperinflation that ensued when the cap was removed evaporated the savings of millions of middle class Russians

As the country tumbled into economic instability, the transition team inside the government, including Gaidar and Chubais, rushed to sell mineral rights, manufacturing, transportation, media, and most importantly, the abundant oil and natural gas deposits, to new corporate entities. These transactions were riddled with fraud, offered at fire sale prices, and enjoyed only by the most well-connected businessmen in the country, who continued to exercise influence over government officials. In many cases, they were one and the same.

The plan was to give Russian citizens a stake in the success or failure of these new corporations.  The implementation was a disaster. A system of vouchers distributed to every Russian citizen was meant to function as a sort of parallel stock market, where each individual, at his discretion, could invest in new enterprises and management groups. When hyperinflation destroyed the wealth and savings of much of the country, desperation created easy targets for predatory opportunists who promised quick returns on investments that would never materialize. Millions of vouchers were bought for pennies or coerced from holders, invested in Ponzi schemes, hoarded and used to purchase controlling shares in new companies, or converted to hard currency, the only thing resistant to the rapidly depreciating value of the ruble.

Assets themselves were sold so quickly that the government barely made any money at all. Instead of slowly ramping up the auctions, beginning with small properties and cooperatives to establish demand and provide pricing stability, urgency drove the government to flood the market. Well-connected businessmen scooped up whole sectors of the economy, worth billions of dollars, at a fraction of the value. The entire gas reserves of Gazprom, valued somewhere between $400 and $700 billion, sold at auction for a meager $250 million. The winning bid belonged to a front company of the same bank managing the auction.

In the span of a couple of years, the country underwent a catastrophic change to the political and economic landscape; the extensive and valuable natural resources, previously sold under state-owned enterprises were now being extracted and sold by newly-formed private entities. The handful of people with the incredible good fortune to acquire those rights in the middle of an economic free fall also happened to be political loyalists and close advisers to the administration leading the charge to privatize state assets. These corporate entities, often registered in Cyprus or other well-known tax havens, evaded enforcement mechanisms and deprived the state of revenue and billions of dollars in domestic investment. Hundreds of shell companies through layers of ownership in various other companies succeeded in shielding the actual agents from public view. No virtuous path to wealth existed; all the parties involved had participated in varying levels of organized crime.

The selective use of criminal prosecution deterred the majority who were involved from exposing the system. The occasional high profile conviction, complete with a lengthy exile to a prison labor camp, helped drive the point home just in case. And the retirees, who had long since sacrificed their bodies to build a system to provide a safety net for their old age, found themselves in a new nation without the slightest interest in making good on those commitments. Those who couldn’t sell their war medals on the black market simply died in the streets.

But it’s Not the Taxes

The argument from the finance ministry was that the primary challenge of converting to capitalism was the state’s overwhelming obligations to pensioners and the destitute. With the state unable to balance its budget, despite the feverish sell off of resources, its only option was to make deep cuts to social services. Revenue simply wasn’t materializing as expected, a condition that was both self-imposed and compounding in severity with each passing day. The living standards of Russians dropped at a pace that had not been seen since the Nazi invasion.

Meanwhile, government officials imposing this new austerity showed no interest in pursuing unpaid taxes from corporate entities owned by government insiders; they continued to implement policies that allowed corporations to shelter their money from taxes in Cyprus.   

Officials in charge of the transition also continued to argue that the fraud, although unfortunate, was both expected and marginally acceptable, claiming that it had no significant impact on the country’s finances. The mantra became Russia needed to “tighten its belt”, all while an estimated $15 to $20 billion dollars in capital escaped the country each year.

In Godfather of the Kremlin: The Decline of Russia in the Age of Gangster Capitalism, Gaidar explained to author and journalist Paul Klebnikov that the rampant tax evasion was more of a feature, not a bug, of the new economic system: “At that time [1992-94] there was a problem with tax evasion. But tax arrears were not a serious problem,” Gaider said. “Naturally, as everywhere else in the world, enterprises try to minimize their tax liabilities and use various methods to accomplish this.”

 Keeping it All Together

Capital flight, organized crime, tax avoidance, and access to the levers of power inside the government characterized much of the transition. Each piece played its own role in preserving all the others; capital flight kept wealth outside the country’s tax system and away from the prying eyes of the occasional anti-corruption prosecutor. Organized crime served as an informal police force, providing ‘encouragement’ to uncooperative partners and preserving monopolies on entire industries through targeted violence. Tax avoidance left the government strapped for revenue and unable to service the basic needs of its population, such as paying an effective and independent police force that wasn’t on the take, or providing services to the 500,000 dismissed Russian army veterans seeking work. These men would easily fill the role of the ‘random Ivan’, busting faces for money in the newly minted private security industry. An extensive network of former KGB, police, military, and national athletes was recruited to act as security, defense, and on-call goon squad for the upper echelons of the new wealthy business class.

But the lynchpin keeping this system together was the infiltration of the power structures at the Kremlin. Every oligarch needed all the components working in concert to succeed, but the handful who survived the organized violence of the early 90’s to transition into a phase of more gentlemanly corporate warfare did so because they enjoyed reliable political support. Their krysha (‘roof’) was the guy at the top who made sure the power of the state to enforce laws was never brought to bear on their own criminal enterprises. Maintaining these channels of influence is vital if you need to, for instance, bend the ear of President Boris Yeltsin to push up the privatization of a media conglomerate you’ve been eyeing. Or to block your rival’s access to his own krysha and undermine his support structure. The pervasive violence is what most people remember about this period, but when the dust settled, the influence over government institutions provided the veneer of legitimacy that outright violence could never enjoy.

Before Paul Klebnikov’s assassination in 2004, he interviewed Yeltsin’s former deputy prime minister, Oleg Sysuyev, on the privatization period:

“Yeltsin made one serious mistake: He gave Big Business the opportunity to draw impermissibly close to him and to his entourage. Nowhere did the law say how close this relation had to be. It was purely dependent on what his [Yeltsin’s] instinct told him about how close this relation should be. As a result, when everybody saw how close this relationship was and how it was evolving, they concluded that these were the rules of the game set by the head of state.”

Klebnikov’s murder was never fully investigated by Russian authorities. His colleagues at Forbes have long argued that it was ordered by Boris Berezovsky, one of the most successful oligarchs, and no stranger to eliminating his political enemies. Berezovsky was the subject of Klebnikov’s book exposing fraud and collusion between the Russian government and the business elite, and an early participant in shaping the system that persists today.

Warning Signs

The post-Soviet period is one of the most explicit examples of institutional corruption, but it should serve as a warning for how the overlapping interests between business and government can be transformed into something that is far more destructive. When the Soviet Union collapsed, the United States rushed to influence the restructuring of the economy. Instead, Russia was sold on a cartoonish version of capitalism forged during the Cold War, where politicians engaged in ideological one-upmanship to prove that they hated communism the most. It was a version of a free market system that more closely resembled Lord of the Flies than any economy in a western democracy. It certainly didn’t resemble the United States at the time, and the fallout from its implementation soured an entire generation on the promises of what our system has to offer.

Our political landscape is evolving toward this export-only version of capitalism, the one where no government is preferable to good governance, and public goods are sold to private enterprises on principle alone. But as the Russian privatization experiment shows, once the infrastructure of corruption is established, it’s increasingly difficult to dismantle. Successive presidents come into office on the aspirations of voters who sincerely support reform, only to be ousted after failing to make good on those promises. In a system where so much power appears to be concentrated in one person, it’s reasonable to think that one person has the ability to fix things. But when so many individuals have a vested financial interest in keeping the existing arrangement functioning smoothly as long as they continue to reap the benefits, even the most optimistic leader can find their efforts stymied. After all, the goal of diffusing power is to ensure that no single person can rig the system in their own favor. But that also means that once the entire system is corrupted, no single person can un-rig the arrangement. These entrenched interests are extraordinarily resistant to institutional reforms that might undermine that advantage, and maintaining influence over the institutions of government itself allows them to ensure that those reforms never materialize.

The corruption that plagued Russia and Ukraine found its first foothold in the privatization of assets, the transfer of property from the realm where public accountability remained in the hands of voters, to a moneyed interest with no such oversight. These corporations became a vehicle through which to plunder money from the government, comprised of critical industries that could never be allowed to fail, but would also never be subject to strict scrutiny.

The U.S. has already begun to experience the difficulty of reversing the privatization of services, and the punitive terms of trying. Private prison projects undertaken with great fanfare such as the case in Hardin, Mont. have resulted in equally great disappointment.  In towns that have privatized emergency services, the results have been deadly. Charter schools have been repeatedly scrutinized for widespread financial fraud, while failing to provide better educational outcomes than traditional public schools. 

Yet despite the failures of high profile projects to deliver on promises of efficiency, improvement in services, and cost-savings, the momentum does not appear to be slowing down. The Republican party has advocated for privatizing elements of education, emergency services, the Federal Aviation Administration, and public roads -- infrastructure that is critical to public safety and equality for all. The Trump administration has injected new life into the effort, arguing that public services are in need of a new style of business-focused management. And the handful of well-connected businessmen currently populating the upper echelons of the administration believe they are just the ones for the job.