Why It Still Doesn't Work

By John Greenwald

Cumbersome, inefficient and corrupt, the Soviet economy functioned, such as it did, because it had its own internal logic. Moscow decreed the production of every tank, shoe and potato; every working-age person was supposed to have a job; and prices were stable. If the end result was not exactly according to plan -- a long-drawn-out failure, in fact -- at least the command system offered a coherent vision of what the plan was.

No such coherence or vision applies to the new Russian economy. Since Boris Yeltsin began shock treatment last January, the result has been a bundle of contradictions. In the industrial city of Rostov, the mammoth Rostselmash factory still makes grain harvesters that no one wants. The clunkers lose up to 15% of the grain as they pound rich topsoil into brick-hard earth. Yet Yeltsin visited the plant last summer and personally guaranteed tens of millions of rubles in state credits to keep the communist relic afloat.

On a busy street in Moscow, pure capitalism is on display. What was once the black market is now legitimate entrepreneurship in the thriving sidewalk kiosks that peddle everything from Dutch chocolates to Japanese tape recorders. Shortages -- and long lines of shoppers -- have diminished even at state-run food stores since price controls were lifted. With inflation racing ahead at an annual rate of more than 1,000%, most middle-class people cannot afford to buy much. Yet high prices don't bother the newly rich who drive by in Mercedes and BMWs on their way to nightclubs that charge $100 a person to dine and dance.

When Yeltsin decapitated the old command system without putting something new in its place, Russia became a battlefield on which the concepts of free enterprise and state control went to war.

On one side are the reformers, led by Yeltsin and acting Prime Minister Yegor Gaidar, who want to instill the basics of capitalism through rapid privatization, price decontrol and tight money to curb inflation. On the other are the conservatives, who argue that such policies will destroy Russia's industrial base and exact too high a human cost.

In the past 11 months, Yeltsin has freed prices of consumer goods and begun selling state property into private hands. But the reforms have ripped Russia's social safety net, worsening inflation, unemployment and standards of living and even creating nostalgia for communist rule. To go forward, officials must next settle the fate of thousands of outmoded factories, where millions of workers produce heavy goods ranging from T-72 tanks to rolled steel. While the reformers want to halt government subsidies to the state- owned dinosaurs and let them die out, opponents argue that the shutdowns would devastate entire regions that totally depend on those factories for jobs. But continued subsidies would require Moscow to print mountains of new money and risk sending inflation into the stratosphere.

In an effort to break the stalemate, Yeltsin last week tried to strike a deal with critics that was aimed at easing economic hardship over the next six months while retaining the main elements of reform. But the deal fell through. Gaidar refused to yield to conservative demands for wage and price freezes or restoration of state control over distribution of resources.

While the political and economic leaders wrangle, Russia is undergoing the most severe economic hardships since World War II. State orders for unwanted factory goods have dried up, shrinking Russia's gross domestic product as much as 23% this year. The number of jobless workers has surged from 59,000 in January to 905,000 today. An estimated one-third of the population now lives below the poverty line. Russian economists expect inflation to hit a monthly annualized rate of 2,200% by the end of the year, further eroding faith in the ruble and threatening to scuttle reform.

Even as hard times sweep the republic, the advent of capitalism has created a new monied class. Communism had its elite, but they kept their privileges discreet. In the absence of laws governing the emerging system, doing business in Russia has become a free-for-all. By taking advantage of the chaos, savvy entrepreneurs, Mafia-style dealers and corrupt government bureaucrats have profited handsomely -- and flaunt it. "The split between rich and poor is growing rapidly," says Igor Dmitriev, deputy secretary of the state statistics committee.

Much of the legitimate new money comes from importing foreign goods or wheeling and dealing with local authorities on behalf of foreign firms. Other entrepreneurs provide services like news or shipping, which once were the sole province of the state. "You will notice that money here is mostly made by middlemen, not in the realm of actual production," says movie mogul Ismail Tagi-Zade, whose ventures, ranging from films to clothing factories, make him something of an exception to his own rule.

But these entrepreneurs, hampered by still prevalent red tape and the sheer size of the country, have no way to expand their businesses to a national scale. And too much of the new abundance is imported. To convert old industries to efficient, high-quality production, Russia must first create a legal foundation for property rights, slash inflation and press ahead with its privatization plans. Such moves would encourage homegrown and foreign capitalists to come forward with their investments and ideas.

Russia's reforms began well when Gaidar lifted price controls. Despite the hardship inflicted on consumers, the high prices lured goods to market and shortages all but disappeared. The big setback came when the Russian central bank began funneling money to cash-starved state industries. That kept the old behemoths in business but whipped up inflation and sent the ruble plunging to more than 400 to the dollar.

The shrinking currency threatens to bankrupt retirees as well as clobber middle-class workers who had been doing relatively well. "I used to make more than 500 rubles a month and felt like a prince," says a former space engineer who currently heads a department in a Moscow technical school. "Now they pay me 5,250 inflated rubles, and I feel totally broke."

A more menacing specter looms in the possibility of hyperinflation, which economists define as price increases of 1,000% or more a year. Russia is headed in that direction, says Jeffrey Sachs, a Harvard economist and Gaidar adviser, as long as it continues to subsidize obsolete industries.

In October the government started issuing every man, woman and child in Russia a voucher worth 10,000 rubles to help purchase state property and speed up the transition to free enterprise. Using the beige coupons as money, people + bought 59 used trucks in the first such sell-off in the city of Nizhni Novgorod. In fine irony, an auctioneer, clad in black dinner jacket, gaveled them off beneath a glowering statue of Lenin.

Scheduled next for the auction block are Intourist hotels, state-owned hard- currency shops and 5,600 major factories, including the Vladimir tractor factory in central Russia.

The strategy could be the reformers' best hope of outflanking the conservatives. "The government is trying to give up its responsibility for part of the economy by turning it over to the managers of these enterprises," says a Western diplomat in Moscow. "The real test will come when some of these managers are faced with bankruptcy, and they come to the government for a bailout, and the government says, 'No, that's not our responsibility anymore.' " The more fundamental question is whether the Russian people will come to understand that they, not the government, are ultimately responsible for their entire economy.

Tougher still could be overcoming powerful conservative resistance to private ownership of land. Laments Gaidar: "Without private land ownership, it is almost impossible to launch the full range of market mechanisms to support agriculture." In desperation, Yeltsin issued a presidential decree last month ordering land to be included in property that Russians can buy with vouchers.

Initial promises of support from the West remain largely unfulfilled, and Yeltsin is still waiting for $13 billion of the $24 billion in Western assistance that the major industrialized countries pledged last April. That money stopped when Russia failed to meet targets set by the International Monetary Fund for stabilizing the ruble and keeping inflation and the budget deficit in check.

The political and economic turmoil hurts Russia's ability to attract desperately needed investments from Western firms. But with a highly educated population of 148 million people, or roughly half the former Soviet Union, Russia is simply too large to ignore. "It's like the Wild West," says John Kiser, a Washington technology-trade expert. "There's no law and no contracts. The only thing you have to build on is your confidence in the people you're dealing with," he says.

Ultimately, the fate of Russia's economy depends on the grit of reform leaders like Yeltsin and Gaidar and the animal spirits of entrepreneurs. In the paradox-riddled new Russia, Yeltsin's struggling reforms still look like & the biggest and best risks that the country can take.

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CAPTION: Collapsing Currency

With reporting by James Carney and Yuri Zarakhovich/Moscow and J.F.O. McAllister/Washington