Russia's Economy: Putin and the KGB State

The KGB state does not tolerate political opposition. It disenfranchises opposition parties, except for the shop-worn communists, who make for a convenient and hapless opposition. They beat and jail prominent opposition figures in violation of constitutional assembly rights. Russia ranks regularly among the most dangerous countries for journalists.2

Conflicts of interest are ignored in the KGB state. Up until mid-2011 when President Medvedev outlawed the practice, ministers and regulators could manage, sit on boards of, or be paid by the very companies they controlled. Although some freedom of the print media remains, state or Kremlin-friendly oligarchs own and control television. The TV nightly news features a resolute Putin (or Medvedev) attending patriotic events, congratulating award winners, and seeming to look after the health, safety and welfare of ordinary Russians.

Under Putin’s direction, a “state mafia” has replaced the street mafias of the chaotic Yeltsin years. At the bottom of this mafia’s pecking order, armies of corrupt tax, fire and health inspectors have taken the place of the brawny young street thugs and racketeers of the Yeltsin era. They can ruin any small or medium-sized business that does not cooperate with them. At higher levels, municipal and regional officials allocate contracts, receive bribes from local businesses, wipe out fines or indictments, and look the other way in the case of unsafe cruise ships. At the top of the ladder, ministers and deputy prime ministers have replaced private oligarchs as heads of gigantic energy and mineral concerns. They deal with their victims politely in fancy hotels and modern offices, but the result is a classic shakedown worthy of the New Jersey mafia.

The KGB mind set has not changed since the KGB’s predecessor organization, the Cheka, was founded in 19183. We can paraphrase Putin’s “Once KGB, always KGB” as “Once KGB, always think like the KGB.” Throughout the Soviet period, the KGB considered itself the unsheathed sword of the state, free to dispense unconstrained “justice.” Rules and laws were for others. At the peak of its power in 1938, KGB (then NKVD) officers declared: “I am the judge, jury, and executioner.” Shortly thereafter, Stalin cut it back to size, executing its head and about half of its officers. 4 The KGB mind set also envisions Russia as encircled by enemies who must be defeated. A cooperative world of global commerce does not exist in the KGB lexicon.

Putin’s Russia is Stalin’s nightmare of an unconstrained KGB that decides “justice” and divides economic spoils. There is no superior authority to rein it in.

The KGB state has created a thug economy. Its directors use businesses as personal wealth-generating machines; they quash potential competitors and take over legitimate businesses once they become big enough to attract their interest. The directors of the KGB economy have accumulated incredible wealth. Putin himself is said to be the richest of the bunch, with a fortune likely in excess of $30 billion.5 There are more Russian than American billionaires on the Forbes lists, although private wealth in Russia is a tiny fraction of that in the United States.

Many praise China’s state capitalism and use high Chinese growth rates to justify its one-party state and political repression. Can we make similar claims about Russia’s KGB economy? Does it yield returns that somehow justify its negative aspects?

The directors of the KGB state praise their economy as an example of state capitalism that nurtures “national champions” (a term Putin introduced in 1997) like Gazprom, Rosneft, and Aeroflot. They remind the public of the “wild capitalism” of the Yeltsin years, when pensions were not paid and inflation was rampant. They point to the crises of the United States and Greece. They claim that wise leaders like Putin and Medvedev, as well as their ministers and civic-minded oligarchs, protect and promote the economic interests of society.

The KGB state controls the commanding heights (Lenin’s term) of energy, commerce, minerals, media, and transportation. Small and medium-sized businesses can operate if they keep their noses clean and heads down and buy off the lower levels of the state mafia.

At the end of the Yeltsin era, most of the energy, transportation, minerals, media, and banking concerns were in the hands of private oligarchs. Under Putin, Russia’s commanding heights became much larger.6 Russia’s national champions are again in the hands of the state or of Kremlin-approved oligarchs. Khodorkovsky, the former owner of Yukos Oil, badly underestimated the brutality of the KGB state. His Yukos was gobbled up by the state in a fake bankruptcy proceeding. Khodorkovsky sits in jail after a second conviction on trumped-up charges. The other Yeltsin oligarchs fled Russia with some of their assets intact, and those that remained follow orders from the Kremlin.

KGB-state businesses are supposed to do two things: advance the interests of the state and provide huge wealth for the system’s directors. Gazprom, the Russian natural-gas monopoly, rattles sabers at Ukraine, Belarus and Georgia when they get too close to the West. Transneft, the oil pipeline monopoly, cancels shipments to punish oil-producing countries that do not toe the Kremlin line. Electricity generators supply free household electricity to bolster regional politicians. When state and private interests collide, state interests are usually sacrificed. Putin abandoned his goal of a trillion dollar capitalization of Gazprom when he turned it into an energy weapon. After all, Gazprom’s capitalization is not that important. There are enough Gazprom assets to strip anyway.

Despite high praise from the directors of the KGB state, the Russian economy will stagnate under this regime for three reasons.

First, insecure property rights retard entrepreneurship, investment, and risk taking. A private company, Eastline, transformed the dreary and remote Domodedovo Airport into the largest and most profitable of Moscow’s three international airports. Eastline took investment risks and applied its entrepreneurial skills. Domodedovo took the lead in traffic from state-operated Sheremetova, ranked consistently as the world’s worst international airport. In May 2011, after Eastline decided on an IPO, Russia’s prosecutor general declared EastLine’s offshore ownership “unacceptable” and threatened to investigate and prosecute. Eastline had to withdraw its IPO. A Putin intimate then offered his services as a peacemaker. He and his partners would call off the prosecutor. In return, they proposed to buy a big chunk of EastLine for pennies on the dollar.7 We await the outcome.

Second, bank loans are allocated to cronies and not to their highest-valued uses. Russian bank regulators and a state-controlled bank recently announced a hostile takeover of the Bank of Moscow from cronies of Moscow’s ousted mayor, Yury Luzhkov.8 Bank of Moscow was accused of making low-interest loans to friends and family. The bank’s head expressed surprise (from abroad). After all, he conducted banking as usual in Russia. In reality, the KGB state wanted to redistribute wealth from those out of favor to those in. The new bank owners will make the same bad loans and not change bank operations. If the lucky borrowers fail to repay, the bank will simply get a new infusion of reserves from the state. All the while, credit-worthy businesses sit on the sidelines without loans.

Third, foreign investment is insecure even if approved at the highest levels. Shell Oil secured an agreement from the Russian government to develop offshore natural gas reserves in Sakhalin without a foreign partner. After Shell had invested $20 billion and was on the verge of going into production in late 2006, Russian environmental authorities stopped the project. It was too great a threat, they claimed, to the fragile environment. After months of pressure, Shell agreed to accept Gazprom as the major shareholder and operator of the Sakhalin project. Shortly thereafter, Russian environmental regulators dropped their objections. Shell invested and brought in its technology, and Russia got the spoils.

British Petroleum signed a deal with private Russian partners to develop offshore reserves under BP management. Russian authorities cancelled BP executives’ visas and harassed its employees until BP ceded management control to its Russian partners, who happened to be cronies of Putin.

The European energy giant E.ON purchased Russian electricity-generating and transmission assets on the promise that Russia was deregulating its electricity market. E.ON and other European energy concerns invested billions in upgrading Russia’s creaky electricity infrastructure. In July 2011, Gazprom announced that it would take control of seventy percent of the electricity market and provide gas at below-market prices. E.ON and other European energy companies that invested in Russia are looking for an exit strategy.

Insecure property rights, political allocation of capital, and unfair treatment of foreign investors explain why Russia’s economy will not modernize and grow as long as it remains under the rule of Putin’s KGB state.

First, as long as property rights are insecure, there is no room for entrepreneurship and innovation. Why take risks and invest if a crony of the state will take you over with a deal you cannot refuse?

Second, Russian capital is in exceedingly short supply; yet it is allocated through a crony system that does not allocate capital to its highest-valued uses. We have the paradox of a capital-poor country wasting the little capital it has on cronies.

Third, throughout the Soviet period, Russian technology lagged badly behind that of the West. Southeast Asia and China, in particular, have grown spectacularly by taking advantage of the technology backlog. The fast-growing Asian countries have learned that Western firms will supply their own technology only if they are offered reasonable returns given the risk. The unfortunate experiences of Western companies in Russia confirm, almost without exception, the inhospitable Russian climate for foreign investment.

Fourth, Russia’s private companies know the danger of becoming too large and profitable. If they prosper, someone from the KGB state will take them over. Therefore, Russian private companies must remain small and invisible. There will be no Microsofts, Googles or Facebooks in Russia. Entrepreneurial success spells eventual disaster.

The business practices of Putin’s KGB state reveal the often-short distance between legitimate government action and outright gangsterism. What the KGB state has done to Shell, BP, E.ON, Eastline, and countless other companies differs little from mafia shakedowns. The difference is that the gangsters are the state, which means, frighteningly, that they are even more powerful than private-sector gangsters.

Putin’s Russia illustrates the brutal power that the state can bring to bear on private enterprise. This brutality is scarcely concealed behind the arbitrary actions of tax authorities, environmental protection agencies, and prosecutors. In other countries, arbitrary state power is more carefully concealed behind claims of public interest and welfare—and is often more limited.

In the Russian case, the costs are more evident. The economy falls well below potential. A people that could be moderately wealthy remain poor. Efficiency losses engendered by corruption cumulate to hold down the standard of living and quality of life. As measured by the Human Development Index of life expectancy, educational attainment, and income, Russia ranks number sixty-five in the world. Russia falls ignobly between Albania and Kazakhstan.9 In terms of per capita income, Russia ranks number fifty-one, between Antigua and Chile.

We cannot say how much higher Russia’s standard of living and material welfare would be in a democratic, market economy not weighted down by the KGB state. But the evidence I have provided on the obvious costs of the KGB state suggests that the Russian people have borne—and continue to bear—a heavy burden.