The Virtual Economy Revisited: Resource Rents and the Russian Economy

On April 17, 2006, the Carnegie Endowment for International Peace hosted a meeting entitled “The Virtual Economy Revisited: Resource Rents and the Russian Economy” with Clifford Gaddy, of the Brookings Institution, and Barry Ickes, of Penn State University. Andrew Kuchins, Director of the Carnegie Russian and Eurasian Program, chaired the session. Gaddy’s and Ickes’ remarks are summarized below.

IMGXYZ477IMGZYXGaddy: Much of what I’ll say comes from our recent article, “Resource Rents and the Russian Economy.” [For the full text of this article, please click on the link to the right.] Economic rent is normally defined as revenue minus the cost of production, which includes transport costs and a normal return on capital. Note that our study uses “natural” prices and production costs, not reported numbers. The difference between the natural price and the natural cost allows us to calculate how much rent is available for distribution. We need to use the natural figures in part because of the excess production costs in Russia, many of which are politically determined.

Rents fall into two categories, formal and informal. Formal rents include taxes and profits. In Russia formal taxes are very high, especially on oil. In his recent televised press conference President Vladimir Putin claimed oil companies keep only 20 percent of their revenue. Formally this is wrong, but informally it may be true.

Informal rents include politically determined price subsidies—oil sells at 31 to 46 percent of the world price in Russia—and informal taxes. The latter class includes bribes, support for the social sector, and excess costs. According to a 2005 study by INDEM, bribes have increased by a factor of nine since 2001. Though the numbers in the report may not all be accurate, rising bribes do make sense in light of rising resource rents.

Russia is often said to suffer from “Dutch disease.” This is usually understood to mean that resource exports cause currency appreciation and undermine the competitiveness of domestic manufacturers. But in truth Russia suffers from “Russian disease.” Some parts of the manufacturing sector actually benefit by charging the resource sector excess costs.

“Dinosaur” heavy equipment enterprises like rail car producer UralVagonZavod have effectively taken advantage of the situation. Transporting oil by rail costs five to ten times more than transporting it by pipeline. The Putin government, however, has slowed pipeline expansion and prevented construction of private pipelines. As a result large volumes of Russian oil move by rail and the energy sector props up firms like UralVagonZavod. While many manufacturers are operating at five percent of their 1980s peak, UralVagonZavod is producing near that peak. Interests like UralVagonZavod form a lobby that helps keep excess costs in place.

During peaks resource rents have accounted for 25 percent of Russian GDP, so they have enormous influence on the overall economy. Under the Soviet system resource rents allowed economic planners to ignore market discipline and make bad decisions. Subsequently vested interests arose to ensure those bad decisions could not be reversed. The system ossified. It is difficult to avoid seeing the connection between the collapse of resource rents in the mid to late 1980s and the collapse of the Soviet economy.
While resource rents have long been a central feature of the Russian economy, the system for distributing them has changed over time. Under the Soviet system planners transferred value from the resource sector to other sectors by setting prices, which was efficient but non-transparent. In the 1990s, with many resource companies now in private hands, Russia needed a new system. But what would induce private owners to share their rents? Insecure property rights. In the 1990s many local and regional governments ran what were essentially protection rackets. Putin merely centralized or “Kremlinized” this practice. The current system has three major problems: it is wasteful, high formal and informal taxes discourage investment, and it has weakened property rights across the board. It hurts not only the resource sector, but the overall economy.

IMGXYZ478IMGZYXIckes: The current situation is odd: oil prices are increasing, but production is decelerating. Why? The obvious answer is Yukos, but we have another explanation. First, overproduction in recent years, driven by insecure property rights, is hurting production now. Second, insecure property rights raise producers’ discount rates (lowering the present value of future production), reduce investment in production, and increase investment in relational capital. As the Yukos case demonstrated, it’s possible to make very large mistakes when investing in relational capital.

During the 1990s we saw private companies like Yukos and Sibneft using technology to extract old oil, while state (or state-allied) companies like Surgutneftegaz and LukOil were doing more exploration and investment in new fields. That’s not what you would normally see, but the more secure property rights of the state companies made their time horizon much longer.

Putin’s dilemma is choosing between control and efficiency. The most efficient solution, private control of the resource sector, is politically impermissible because the sector is just too big. A few resource owners would control the economy and the state. So Putin has chosen a centralized protection racket.

According to the conventional wisdom natural resources are bad for development. This idea has a long history, from Adam Smith to Joseph Stalin. The economic historian Gavin Wright makes a strong argument against this idea, pointing out that resources are not manna from heaven. Rather they must be discovered and developed. For example, in the 1870s the US overtook Chile as the world’s leading copper producer thanks not to superior “endowments,” but rather superior technology. [For the full text of Wright’s paper, please click on the link to the right.]

One can also see this as a top-down versus bottom-up debate. In the top-down model the state controls rents and favors exploration, but risks big mistakes in choosing projects (like Russia in the 1970s and 1980s). In the bottom-up model you get the market as a discovery process, but this requires effective property rights, or overproduction will provoke a backlash. So for Russia the biggest question is this: how can you implement the efficient solution in a way consistent with democracy?

Q&A
Q: Are informal taxes going to individuals in the Kremlin or other sectors?
Gaddy: It’s hard to measure the flows. People would actually rather pay informal taxes because then they can control the destination. Some money is going into pockets, but it’s impossible to figure out just how much. This comes not only from the desire to profit; control over rent distribution gives an individual political power. Price and quantity changes in the resource sector can affect rent distribution in different ways.
Ickes: Informal taxes basically give the government a chance to price discriminate.

Q: One of you said, “Which system will Russia choose?” Why the future tense? Also, in the 1990s Yukos and Sibneft felt their property rights were growing more secure, and that’s why they produced more. They didn’t start worrying until 2003-2004. Production decelerated when property rights weakened.
Ickes: Prices were much lower in the 1990s. High prices didn’t come around until 2001-2002 [and production growth actually decelerated soon afterward]. This is the real paradox. Yukos produced a lot, but it didn’t add to its reserves like LukOil and Surgutneftegaz.
Q: The state could be dictating production increases, not the market. Private companies may have chosen old fields as a point of entry, intending to diversify later.
Gaddy: Some foreign players in Russian oil think the question hasn’t been finally decided, that the top-down approach will be so disastrous as to force reconsideration.

Q: The Soviet army used to get lots of rents. The “energy superpower” idea makes you think there would be energy sector investment, but this isn’t happening. So where, on the macro level, are rents going? It looks like a multi-level welfare system with different clans benefiting.
Gaddy: Large changes in price and/or production alter the distribution of rent. Wright showed that increased attention to dividing rents leads people to ignore wealth creation. If the pie grows you can skate by. But if the pie stops growing there’s lots of fighting: who will get the next marginal increase and where will it come from? So there’s zero attention to production. If you think long-term, other actors grab your share. People acknowledge the energy bubble can’t continue indefinitely, but they act as if it will. As for the army, don’t forget informal rents. The defense industry is still getting by thanks to business from LukOil, Gazprom, etc., which are highly dependent on energy rents. The Urals defense plants aren’t what they once were, but they only persist at all thanks to energy rents.

Summary prepared by Matthew Gibson, Junior Fellow with the Russian and Eurasian Program at the Carnegie Endowment for International Peace.