• The inflation in Russia is now caused mainly by supply-side factors.

• The budget deficit is caused not by overspending but by the eroding tax base due to the prolonged general depression.

Roots of Inflation

While in the first year of price liberalization (1992) inflation was largely a demand-pull phenomenon rooted in preceding goods shortages and money overhang accumulated in the Soviet period, inflation very quickly developed into a multifactor phenomenon with the two underlying main factors being supply-side pressures and the "catching up with world energy and material prices" effect. Consumer goods shortages were largely eliminated by 1993 due to skyrocketing prices, falling real incomes, eliminated savings and increased imports. The money overhang all but disappeared. By 1994 there was no appreciable demand-pull to talk about. While falling output in 1992 and 1993 was largely explained by a sharp reduction in military production and the resulting macroeconomic fallout, the further contraction in 1994-96 was due mostly to inadequate aggregate demand, particularly in capital investment and personal consumption.

By early 1996 prices of electric power rose 2.4 times faster than average wholesale industrial prices, prices of fuel 1.9 times faster, ferrous metals and petrochemicals 1.3 times faster. While domestic output fell, booming exports of energy and raw materials helped push up domestic prices. The after-effect on prices of final demand was particularly strong in an economy that is largely devoid of free competition, trapped between barriers to market entry and crippled by extensive criminalization. Larger imports of consumer goods also helped push up domestic prices due to the initial gap between the prices of imports and domestic goods. Supply-side inflation subsided only in 1996, when most domestic prices came close to or partly overshot the ceiling of world prices and could not rise much further without destroying exports completely.

Neither was this latter-day inflation caused by net deficits in the government budget or excessive money supply. Table 1 summarizes the relevant data for 1991-96, which shows that there is no correlation between net budget deficits and increases in money supply, particularly in 1995-96 when practically the whole gross deficit was financed by the sale of government bonds and by foreign credits. The ratios of M0 and M2 to the net deficit (i.e. gross deficit minus sales of government short-term paper and IMF credits) fluctuated wildly from year to year. The figures for 1994-96, are particularly interesting. In 1994 both ratios fell sharply, but they exploded in 1995, when the net deficit was practically eliminated. Considering that inflation in 1995-96 was down compared with 1994, one would expect the opposite to have happened.

Effective aggregate demand deteriorated sharply. Money supply in real terms (M2) fell by 51 percent between February 1992 and 1996. The Russian economy, by all accounts, is severely undermonetized. There is simply no evidence to claim that the Russian government or Central Bank were issuing money in excess of the needs for the circulation of goods and services. Quite the opposite is true. The shortage of money in today’s Russia is a well known phenomenon from which the population, business firms, and the government suffer the most. The only exceptions are the banks and the newly rich.

The above analysis indicates that the restrictive fiscal and monetary policies of the Russian government, particularly in 1995 and 1996, were unnecessary as a means of fighting the nonexistent demand-pull inflation. By restricting aggregate demand, the government helped prolong depression in the real sector while failing to restrain supply-side inflation. The analysis also suggests that fiscal and monetary restriction are no longer needed as the principal instrument of economic policy. In the present conditions they are doing more harm than good.

Once we accept a predominantly supply-side explanation of Russian inflation, the budget deficit can be seen in a more realistic light. Table 2 shows that the deficit is the result not of excessive government spending but of inadequate revenues. (Therefore it is a "passive deficit.") Government expenditure has fallen substantially both in real terms and relative to GDP. Government revenue in real terms fell steeply in 1996, usually explained by the particularly weak tax collection due to the election year. A more relevant long term explanation is the eroding tax base, a phenomenon that is natural in a depression of such magnitude. One cannot expect government revenues to keep up with income when the latter is falling below 60 to 70 percent of its normal level. (The intention to somewhat restore revenue in 1997 is considered unrealistic by most experts.

Thus some increase in the real amount of government spending is possible without running the risk of more inflation. As a first step, we suggest that the government should start paying its own arrears accumulated in 1995 and 1996 both to firms (for goods and services ordered and received by the government) and to individuals (government employees and pensioners) as provided by the approved budgets of those years, even though such payments would exceed government revenues. (Total arrears in the economy are now conservatively estimated to be in excess of 300 trillion rubles, equivalent to 150 percent of monthly nominal GDP. It is normal for companies to be in arrears on wages for three to four months or more, and in some cases wages have not been paid for more than six months. Some companies are paying employees in products instead of cash, and municipalities are forced, where possible, to distribute basic food supplies directly—via food coupons and otherwise—on an emergency basis.) This would immediately give a boost to the economy in terms of larger aggregate demand and at least help stop the current reduction in GDP and industrial production.

As an accompanying step, the possible increase in the federal deficit should be financed by low-interest loans from the Central Bank, not by additional sales of government securities or new loans from the international institutions. The reason is that the current market in government securities is oversold and is effectively crowding out investment in the real sector.

This boost in demand would result in an adequate expansion in supply. The economy is working well below capacity, and a modest addition to aggregate demand should not create inflationary pressure. On the contrary, if inflation is mainly supply-side, as we have argued above, then an increase in output should lead to falling fixed unit costs and also to some decrease in variable unit costs due to increased labor productivity and the spread of energy costs over a wider product range.

The savings rate in the higher income brackets and the profits generated in the banks and some "small", (unregistered and weakly monitored) private business remain high. But capital investment in the economy fell drastically in real terms and as a share of GDP, due to the deep depression, the virtual disappearance of net profits, and the disastrously high interest rates. (The contribution of foreign firms and joint ventures to capital investment was relatively small.) This gap became one of the principal barriers to economic recovery. Eliminating, at least minimizing, that gap should be one of the main aims of Russian economic policy.

To help economic recovery, besides eliminating legislative and administrative barriers facing foreign investments, government investment should be increased as part of a well-formulated industrial policy. The government should invest in enterprises, or jointly with enterprises, on the basis of profit-sharing deals that would provide fast added revenue to the budget or to special off-budget funds, while creating jobs and raising the real income of consumers. A rise in government investments thus would not spur serious new inflation. These investment should target export-oriented industries (oil, nonferrous metals such as aluminum); as well as food and consumer goods industries (new investments would spark a fast production recovery and cash flow).

Source: Calculations based on Russian Economic Trends, Working Centre for Economic Reform, Government of the Russian Federation, Quarterly Report, Volume 5, No. 1-2 and previous years; Monthly Update, December 1996.

Table 2. Russian federal budget and GDP, 1992-97, (trillion rubles)

a. Calculated assuming a conservative uniform share of depreciation and depletion (10 percent of GDP). In fact, this share tends to rise when GDP falls. In 1990 it was to be reported as high as 15 percent. If that share was extrapolated, net investment would be negative starting in 1992.