Russia's Virtual Economy Part 4 - U.S.-Russian Business

The range of behavioral options in the virtual economy was broad. The ability to use nonmonetary mechanisms to pay taxes to governments and bills to the natural monopolies fundamentally changed the range of opportunities for action available to Russian enterprise directors. By allowing enterprises to settle their obligations by delivering goods for which there was no effective demand, the governments and the monopolies offered an incentive to avoid restructuring. For many enterprises it was easier to produce such goods than to restructure and earn additional monetary income to pay bills in cash. Producing those goods allowed for use of idle capital and labor. In short, offsets and barter permitted some enterprises to survive without restructuring. To represent the full range of choice, not only market-oriented activity but also behavior characteristic of the virtual economy, Gaddy and Ickes (2002) employed the notion of a two-dimensional space, called r-d space. The following sections outline their model.


	Liberalization revealed the distance that a Russian enterprise would have to travel to compete in the world economy.

Market Distance, d

The impact of liberalization on the Soviet economy can be expressed with a spatial metaphor: liberalization revealed the distance that a Russian enterprise would have to travel to compete in the world economy. Let d designate the enterprise’s “distance to the market” at the start of transition. Clearly, d depends on the enterprise’s initial endowments of the things that matter for market viability: physical and human capital, as well as the enterprise’s marketing structure and organizational behavior, but also the characteristics of the good that the enterprise produces (its quality and cost of production). Formally, define an enterprise’s d as the amount of capital expenditure needed to enable the enterprise to produce a product that is competitive in the market. The fundamental reason for measuring d in terms of the investment cost is that transition causes a divergence between the value of existing (inherited) capital and that of newly installed capital.

One may begin to grasp this point by recalling what happened to traditional models of investment in market economies during the energy crisis of the 1970s. Those models predicted that investment would decline, given the tremendous increase in the price of energy. In fact, however, spending on new equipment and buildings soared. The reason for this discrepancy between model and reality was the divergence between the value of installed capital that was energy intensive and new capital that was energy saving. The conventional model ignored the sharp decline in the economic value of the existing capital stock as a result of the 1973 energy crisis. Installed capital had been the result of investment decisions based on low energy prices; hence, its value fell dramatically once energy prices quadrupled. This in turn only increased the demand for new investment in energy-saving equipment. The result was a divergence between the value of installed capital (which lost value) and that of new capital (which had full economic value). In the Russian context, measuring market distance d by the need for new capital investment is a way of capturing the cost of filling the gap between the value of inherited (Soviet) capital and new (market) capital.

The level of d differs widely among enterprises in the economy. An enterprise that already produces a product it can sell in world markets at a price above cost will have a value of d equal to 0. A completely noncompetitive enterprise will have an enormously large d. Everyone else will be somewhere between. For example, an oil-producing enterprise will have a very low d. Its product is already right for the market. It may need only relatively small investments in marketing, and so on. A Soviet-style machine tool producer, in contrast, is likely to have a long distance to travel.

The distribution of d’s in transition economies differs in two respects from that in market economies. In transition economies the range of d’s is greater and the distribution is more skewed. Both differences stem from the dissimilarity in the process of entry and exit in market and planned economies. In a market economy, whether or not a new firm attempts to enter an industry depends on the founders’ expectations about the new firm’s competitiveness. They will enter if they expect the firm’s potential costs to be lower (its productivity to be higher) than those of existing firms. No firm enters an industry in which it expects it will be noncompetitive. Over time the competitiveness of some firms declines, so d increases. But if a firm in a market economy has too high a level of d, it will be forced to close. Competition and hard budget constraints cause high-d enterprises to shut down.

In a transition economy, in contrast, some enterprises have very high d's that would not be observed in a market economy. There are several reasons for these high-d enterprises. First, in socialist economies entry was not determined by expectations of profitability or competitiveness but rather by the need to fulfill plan targets. Second, insulation from the world economy meant that enterprises were created that produced goods for which the country might not have had a comparative advantage. Third, especially in the case of Russia, the priority given to defense production led to a proliferation of enterprises that produced goods whose market collapsed with the end of the Soviet Union. Fourth, since the geographic location of industry in the Soviet period was based on ignoring transportation costs (as well as the costs associated with extraordinarily cold temperatures), the location of enterprises was also a factor in increasing the d in many cases. For all of these reasons, the distribution of the d’s in Russia at the onset of the transition had a much higher mean and was more skewed to the right than in a mature market economy. This extra mass of high-d enterprises was the burden of the Soviet legacy. And it was this burden that was the essence of the restructuring problem: so many enterprises had to all radically reduce their distance to the market at the same time.

One way to think of the purpose of economic reform is to reduce the average distance in the economy. This occurs through three means: (1) exit of high-d enterprises; (2) entry of new low-d enterprises; (3) and reduction of the d of surviving enterprises. In an ideal market world, market distance would be the only condition that characterized the state of an enterprise. If the only important difference in enterprises were their initial level of d, then policies that put pressure on existing high-d enterprises and encourage creation of new low-d enterprises would have the effect of pushing the distribution in the direction of the market.


	Enterprise directors relied heavily on the accumulation and use of personal connections. Relational capital was passed forward to the post-Soviet system in a deceptively simple manner: it was spontaneously privatized.

The conventional view of restructuring, that reform means reducing d, assumes that each enterprise has one set of resources — its physical and human capital — that it must use ever more efficiently in order to survive. The virtual economy view, in contrast, posits that some enterprises have another resource, relational capital, which they can draw on to enhance their chances for survival. Relational capital is the stock of goodwill that an enterprise can use to avoid the strictures of the budget constraint. An enterprise that has high relational capital can undertake transactions (bartering, using tax offsets, delaying payment) that other enterprises, with low amounts of relational capital, cannot get away with. To put it another way, relational capital is goodwill that can be translated into the ability to continue to engage in production and exchange without reducing the distance to the market. It is therefore the existence of this second dimension that can explain the persistent survival of high-d enterprises in the Russia of the 1990s.

At the onset of transition enterprises differed in their inherited relational capital — call it r — just as they differed in their d. Some enterprises (or their directors) had very good relations with local and/or federal officials. Relations with other enterprises also varied.

The relational capital of Russian enterprises was initially accumulated in the Soviet system. Enterprise directors relied heavily on the accumulation and use of personal connections. Relational capital was passed forward to the post-Soviet system in a deceptively simple manner: it was spontaneously privatized. And here lies an important aspect of economic transition in Russia. As Hewett (1988) described, plan fulfillment in the Soviet economy required enterprise directors to use informal skills. Their ability to accomplish this, and their position in the economic hierarchy, was critical to their incomes. While directors earned income from these positions, they did not legally own the source of these incomes. The demise of the planning system, which had already begun with Mikhail Gorbachev’s reforms in the late perestroika period, had the effect of increasing the autonomy of enterprise directors. With the start of economic reform and privatization, the role of the enterprise director increased; other mediating actors (planners, party officials) played less and less of a formal role in economic allocation. Directors used this opportunity to appropriate the returns to the relationships they had developed and cultivated under the previous system. However, in order for directors to appropriate these returns, the enterprises had to continue to operate. Much of the relational capital was both enterprise specific and person specific. To the extent that it was enterprise specific, the director could not cash out the relational capital. The primary form of these connections was relationships with directors of other enterprises, often in related lines of activity, and with ministerial officials and local government officials. The relational capital was worthless to the incumbent director unless he remained in that particular enterprise. He could not leave the enterprise and take the relational capital with him. Furthermore, because it was person specific, he could not sell it to someone else. Instead, in order to appropriate the rents accruing to his relational capital, he had to remain in the enterprise and keep it operating. The privatization of relational capital is thus an important part of the explanation of why directors fought to keep open enterprises that had few prospects in the market economy.