American Enterprise Institute

December 18, 2007

[Edited transcript from audio tapes]

11:45 a.m.	Registration and Luncheon
12:00 p.m.	Panelists:	Andrei Illarionov, Cato Institute Ann Wrobleski, International Paper
		Desmond Lachman, AEI
	Moderator:	Leon Aron, AEI
2:00	Adjournment

Proceedings:

Leon Aron:   First, a technical announcement. As sometimes happens with the corporate types,  Ann Wrobleski has been called down to the International Paper Headquarters in Memphis and will not be able to join us today.  But the rest of us seem to be fairly eager to start.

So I will begin by saying that the title of today’s event “What’s Wrong with the Russian Economy?” may have struck, at least some people, as rather odd.  After all, this is the economy that has been in its eighth year of growth just under seven percent.  It is the economy that just posted a record 7.4 percent increase in the overall investment in its economy.  The non-resident investment, that is foreign direct investment in Russian economy, has skyrocketed from about $26 billion in 2006 to $45 billion; at least this is the projection this year.  And the overall investment has reached around $86 billion this year according to Deputy Prime Minister and Minister of Finance, Kudrin.

Moscow, specifically the Ritz-Carlton on Tverskaya, last November, became the scene of the International Herald Tribune’s Annual Luxury Convention and, obviously, not just in Moscow but virtually in every large city, you could see a sign of real prosperity and growth.  So it may indeed be an off-topic, but we are paid at AEI to ask odd questions.

Just to give you a bit of a foundation for this oddness, all of a sudden we are witnessing a rather sharp increase in inflation, not just somewhere above the eight percent that the government was trying to get this year, but well above, I think, 10 percent and perhaps as high as 11 percent -- we will see.

The budget surplus has gone down from about 7.5 percent of the GDP to under 3 percent of the GDP this year.  Why?  Because the formerly sacred cows whose birth one of our panelists midwifed, this so-called fund, “Fund for the Future Generations” now has been renamed “The Fund of National Welfare,” I think, rather tellingly, and been touched for all manner of politically-sensitive spending including pensions and salaries.

The political sensitivity of this inflation uptake was such that the government, in fact, tried to institute price controls for food products and that is no joke because in the provinces particularly, the prices for such staples as the vegetable oil, eggs or cheese in some provinces doubled this year.

So before I introduce my two other panelists who of course will delve into this in a greater and fascinating detail, let me just mention a couple of other things.  One of which the policies promulgated by the men nobody remembers and that is the current Prime Minister, Zubkov, beyond whom we all have apparently moved but he is still in office.  And his policies were those of greater state control over prices in general, what you call the balanced regulation of the food market, subsidies, particularly to agriculture and so on and so forth and the tariffs.

So all of that, of course, does not bode very well for the inflation outlook, but I think it is also a symptom of some larger problems and flaws in the Russian economy papered over by this inflow of petrodollars.

Let me quote an e-mail that I received from a very good personal friend who heads the Moscow office of a major international investment firm.  When I invited him to join us, he could not but instead he wrote, among other things, “Russia’s economy has been, for a decade now, blasting at full throttle.  But the decrepit machinery is laboring under growing burden of statism and corruption.  Inputs, human and otherwise, are inadequate while more and more output is required.  Beneath today’s wall of money brilliance, Russia’s economy is plainly inefficient and in a global context, increasingly non-competitive.  Inflation, I think, is a sign of this reality.”

So we will see if that is an unduly harsh statement or whether, at least, in part our panelists would concur.

And speaking of our panelists, we are very fortunate to have them today.  The bios are in your folders, but let me just briefly say immediately to my right is Desmond Lachman who joined AEI after serving, among other places, as managing director and chief emerging market economic strategist at Salomon Smith Barney.  He also served as deputy director at the International Monetary Fund’s Policy and Review Department and is considered one of the top specialists on monetary and fiscal matters in international economy.

And Andrei Illarionov is one of those people that moderators say need no introduction and then proceed to introduce.  I will just say only that Andrei, for five years, was a personal economic advisor to the president of the Russian Federation and his Sherpa at the G-8 summits.  Before that, he served briefly in the Russian government in 1993 and 1994 under then Prime Minister Viktor Chernomyrdin.

Now, those of you who have come to the game of Russia-watching relatively recently probably have noticed that Andrei is wearing several hats including one of, again, to resurrect - but a lot of Soviet words are now being resurrected - that of a political dissident and his articles are wonderfully written and terribly incendiary.  I follow him personally like most of the prominent Russian opposition publicists and writers largely on the Internet.  I strongly recommend Ezhednevniy Zhurnal but of late, and that copy is in your folders, he has been publishing in the United States and his very recent article in the Washington Post is included in your folder.  With that, I would ask Desmond to start.

Desmond Lachman:  Thank you very much, Leon, for inviting me to this panel and thank you for asking me to look into the question of whether or not inflation is a problem for Russia going forward.

As you mentioned, it is rather strange to be talking about Russia having problems on the economic front with such very good performance the last seven years.  And I only embellish a little bit on that in saying that Russia has become a favorite on Wall Street as a place to invest; together with Brazil, India and China, Russia is now regarded as being one of the bricks and what people on Wall Street are happily doing is extrapolating Russia’s performance over the last seven years indefinitely into the future.  And what they are doing is they are arriving at conclusions, at least government SECs is arriving at the conclusion that maybe in 15, 20 years Russia is going to be surpassing Germany as an economy.  Certainly, it is going to be surpassing Britain and France.  And I just find that my experience tells me that that is a little bit fanciful.

The two reasons that I would cite, you know, that why I would be skeptical would be, one is what is going to be happening to oil prices going forward and the other is the inflation which I will talk about.  Just as far as oil: what tends to happen at the peak of a cycle is we begin to talk about peak oil.  You know, we are running out these resources.  There is no way that the well can produce resources, but I’m old enough to remember the Club of Rome in 1973 talking about how oil was going to go through the roof. 

When I look at where we are in the international cycle, I have got a rather dim view of what is going to be happening to the U.S. economy, Japan, and Europe, and if we do get a significant global slowdown - as I expect we will - I’m not too sure that we are going to see oil sticking around at $90 barring, of course, a supply disruption.  I should also mention that alternate fuel becomes efficient at round about $40, $50 a barrel, so to think that oil is going to stay at $90 forever, I think that that is a grave mistake on the Russian’s part.

Likewise, what Leon just mentioned, the uptake in inflation has to be troubling particularly when it is occurring in a country that has got a history of inflation.  What one finds is that countries that do have a history of inflation, it is very difficult to get the inflation down.  The Russians have succeeded in doing that, but people have memories.  When inflation begins picking up, it tends to destabilize.

Before I go into the inflation question, I would say that I do not want to gainsay Russia’s tremendous achievements in the last seven years.  You know, you look at GDP.  GDP has grown by something like seven percent in real terms a year.  If you look at it in dollar terms, it is really very impressive; it has quintupled to something like $1.2 trillion, which makes it a real economy.  Inflation has been brought down, budget has been running, surplus is on a sustained basis, you have got the current account running strong surpluses. 

Russia has now got something like $450 billion in international reserves, making it one of the big holders of international reserves after places like China and Japan, and they built up stabilization fund.  So while I am not too optimistic about Russia maintaining its rapid pace of growth of the last seven years, I do not see Russia running into the kind of financial crisis at anytime soon given that it has really got a very substantial savings on which it could draw.

When we look at Russia’s economic performance in the last seven years, I think that one could really look at two kinds of factors contributing to that performance.  The one is good policies, you know, which I think -- certainly nobody who was around in 1998, during the crisis, would have thought that we were going to see a fiscal and monetary policy responsibility of the kind that we have seen in Russia at the last seven years.  And there was structural reform of significance during the first Putin term.

So those, I think, laid the basis for good performance.  But we should not turn a blind eye to the fact that oil trebled in price from roughly $30 a barrel - I’m talking about international prices not the euro prices - to something like $90 a barrel over that period.  Furthermore, Russia was starting - off the 1998 collapse - Russia was starting with two picket furniture.

One, it was starting with a lot spare capacity that they could draw on so they did not really need a very high rates of investment to register solid growth.  And second, they had a very great competitive advantage, in that, the currency really just collapsed during 1998, so they have had the benefit of a very good currency.

Looking forward, I think, things look to me, at least, a lot more cloudy.  Inflation is picking up and that is what I really want to talk about in a little bit more depth.  Budget, it looks like the budget is slipping.  Leon has mentioned that you are already down significantly in 2007, but if you look out to where they are going in 2008, 2009, the IMF is reporting that what were surpluses of something like close to eight to nine percent of GDP, are going to be balanced and you require a high price of oil to balance.

So going forward, that does not look too good.  The reforms seem to have ground to a halt.  Investment at 20 percent of GDP is pretty low, and then what you have run out of is you have run out of the spare capacity.  IMF thinks that you are very close to having exhausted the spare capacity and the competitive position, as I put up a slide, looks like that has largely been eroded; although, IMF thinks that maybe the Russian ruble is still undervalued by something like 10 percent.

Before I get into the slides on the inflation, I just thought I would put inflation in a little bit more of an international perspective.  If there is one thing that Central Banks in the major countries of the world - I’m thinking of the G-7 countries - but I’m also thinking of places like Mexico and Brazil and a whole bunch of places in Asia, is that high inflation is not a good idea.  In fact, consensus seems to be building around the idea that something like two percent, three percent inflation is optimal.  We talked about the great moderation in the global economy; that has explained very rapid growth. So the idea is that you really do not want to have inflation in double digits.  That is both harmful to growth and not very good for distribution of income.

The other thing that there is a consensus about is that you want Central Bank independence and you want Central Banks to be able to run monetary policy in a way that gives them room for maneuver, which means that it is best done with clear inflation targets and in a floating exchange rate environment.  And I would suggest that Russia does not look too good in that standing.

Let me now just say a few words about Russia’s inflation and I’ll put up a few slides.

The first slide just indicates that Russia has achieved a great deal over the last seven years. I should have taken the slide back further which would have been more impressive, Russia coming down from triple digit figures to round about 7.5 percent inflation, whichever way you want to measure it.  By April of 2007, Russia gets down to something like 7.5 percent.

As Leon mentioned, since April things do not look that good.  What is occurring is that Russia’s inflation is picking up.  The estimates that I’m seeing now are that Russia, even though the Central Bank has been progressively reducing its inflation target from 11 percent in 2005 to eight percent in 2007, inflation is going to close out the year at something like 12 percent this year.

What is bothersome is that core inflation, when you strip out food, is picking up and I would also be worried about real wages.  If you look at the lower line, that real wages have been very sticky round about over 10, 12 percent, and that was fine when Russia’s productivity was increasing at a very rapid rate, but if we are running out of spare capacity and productivity is slowing down, 20 percent nominal rate of increase in wages is not a very good idea.

Now, if you look at the inflation in Russia, 40 percent of the consumer price index is food prices, and it would be fair to say that Russia has been subjected to an inflationary supply-side shock.  International grain price is growing through the roof - really makes it difficult to keep down inflation in a country that has in its index so much of food products.

But I would say that that is only half of the story.  You know, that part of the story does not bother me.  I think of inflation as being a monetary phenomenon.  What bothers me is the loosening of policy and the way in which they are handling the balance of payment surplus gives me pause as to where Russia might be going forward and makes me worried about whether Russia is not building up an inflation problem for itself.

The issue is really, in the case of Russia - and I would say Russia does not differ in that respect from other oil producers.  We are getting these problems in the Gulf area - places like Saudi Arabia.  We have got Argentina getting renewed inflation basically because what they are doing is they are holding fixed exchange rate.  It is not really totally fixed; but basically, they are not allowing it to move at time that you are getting very strong inflows of foreign exchange.

Russia has been successful, up to now, in preventing the orange line, which is the foreign exchange reserves, from translating into very rapid monetary-based growth basically through fiscal sterilization.  A lot of the stuff that comes through on the current account goes into the government’s coffers.  They have set up this stabilization fund.  They have not spent all the money, so there is sterilization of those flows.  The Central Bank is not that good at the sterilization issue and that is really where my concern comes.

You can see it in this chart.  Basically, what this chart is doing is it is breaking down the composition of the foreign exchange flows between the current account flows, when a country can get a balance of payment surplus - meaning that its foreign exchange is increasing - is either through the current account - basically meaning it exports more than it imports - or through capital inflows.  And what you are seeing in this chart is that in 2005, the black part below the line, there were capital outflows and the grey part was that there is a big current account surplus.

The current account surplus is still there but you are seeing that, progressively, the current account surplus is getting reduced as Russia imports more, spends more money, pulls the goods and is not exporting quite as much.  But what is occurring is because as I will mention shortly, because of the exchange rate policy that they are following, they are attracting capital inflows mainly through the banking system borrowing abroad and bringing the money in and the Central Bank is not sterilizing it.

Why I’m concerned on the budget surplus side, as we have already elaborated, this chart just shows how the budget surplus - that is the grey line - declines progressively, going down to round about a zero budget position because what has occurred is the Russians have announced a medium-term budget plan that purportedly is not going to blow the budget figures because what they are going to do is they are going to spend the money and then run up to the election now in 2008, 2009, and somehow, in 2010 just ahead of the 2011 election, they are going to go in for a fiscal restraint.

I have been around the block a few times and I have heard those promises before.  This looks to me like its fiscal profligacy, which is a big mistake particularly if oil prices come down.

Let us just look at the exchange rate.  What I mentioned is, and you can see it very clearly if you look at the black line, basically Russia got a euro basket that has got roughly equal proportions of euros and dollars in it.  But Russia is basically keeping its exchange rate, not allowing the exchange rate to appreciate even though it has got very strong inflows at a time that inflation is rising.  And what that does is it just makes it very attractive to borrow money abroad to bring it into Russia, because what you are doing is you are borrowing at say, in the U.S. you are borrowing at 6 percent, Russian interest rate should be round about 15 percent.  You know that the currency is going to appreciate, so by the time you are going to repay the loan, you are going to make money on the exchange rate, so it looks like it is a no-brainer because the currency can only go in one direction, at least in the near term.

The trouble, though, of course, is what all of these is doing is it is causing the money supply to really be at a rather elevated level.  You know, what you are looking at is from 2004, money supply was growing.  If the broad money supply - look at M2 - is growing by something like 30 percent, we are now looking at annual rates of round about 50 percent.  You could argue that Russia is not a particularly monetized economy.  There is room for real money to grow, but generally, what does not happen is that if inflation is picking up and interest rates are not being raised, the Central Bank cannot raise interest rates too a high because if it tries to raise the interest rates too high with a fixed exchange rate, all they are going to be doing is they are going to be attracting more capital inflows that will be difficult to sterilize.

There has got to be some concern about the Russian banks.  You know, are they borrowing too much in foreign currency?  You know, that we have seen these problems before that they could be getting too exposed, having currency mismatches.  In the end it turns out not to be a good idea.  That is how you get banking crises periodically.

Finally, let me just say that you are seeing on this chart what is happening to Russia’s real effective exchange rate.  You see that it goes from 100 to 40 during the crisis, but they basically lost that compared from what is going forward.  I do not think this is a problem in the next year or so, but it does seem to me a problem that if Russia has a very high rate of inflation, all prices come down; you could be exposed on the balance of payment situation.

Finally, let me just say that way in which the Russian seem to be responding to this is not changing the basic macro policy, which is what I think they should be doing.  What they are doing is they are trying to suppress the inflation.  You know, it is either you have got a price control here or you have got an export freeze there or you try to get a voluntary arrangement.   You do not really attack the underlying cause of the inflation, which I think is excess of money supplies. 

So what my recommendation for the Russians would be, to be more prudent on the fiscal policy; not to be spending as if there is not a tomorrow; to be keeping up the stabilization fund; siphoning off on the sterilization side.  And on exchange rate policy, what they should be doing is they should be allowing the currency to float because they have got a choice that the argument that you would get in a place like Russia would be, “We really want to keep the exchange rate competitive.  That is the reason that we are not allowing the currency to appreciate.”

That is a complete, at least in my view, a complete misconception because, basically, the choice that the Russians have is they can either get the real effect of appreciation that is going to occur and that has been occurring.  They can either get it through moving the nominal exchange rate, allowing the nominal exchange rate to appreciate and have low inflation, or they can keep the exchange rate fixed and have high inflation.  I do not think that is a very good idea for Russia to go down that route, and that is basically the reason why I think, that inflation is something that should be taken seriously.  It should not be dismissed as just being an issue of supply-side shock.  That looks to me as if we are talking about something a lot deeper.

Leon Aron:  Thank you very much.

[No audio from 28:54 to 29:54]]

Andrei Illarionov:  That was such a wonderful topic in which Leon has invited us to come.

Before going to what I’m going to talk about with this presentation, I have really a serious temptation to make three comments.

First, concerning the topic - the very title - it is really art of PR.  I mean, not my title - the title Leon has proposed for us “What is Wrong with the Russian Economy?”  And I wonder, even the topic will be “What is Right with the Russian Economy?”  How many people would be attracted to this title as I come to discuss?  Probably not too many.

The only issue - Leon was very kind to indicate some other publication by some other authors, but I would like to attract your attention to the piece that also you can find in your folder.  A piece that has been written by Leon almost two months ago and it is titled so elegantly, We’ll Always Have Putin.

As it is, looking at today’s and yesterday’s news, it is probably could not be more timely.  It looks like and probably they have consulted Leon’s view upon a timing called a United Russia Congress to make those announcements.  And also, since we are under some kind of propaganda pressure, not only there in Moscow in Russia, but also probably even here, and looks like for a current generation, the whole history can be divided in two parts:  What was before Mr. Putin came to power and what has happened after that. 

So that is why it is really interesting to observe that even in our conversations, even some kind of old economic indicators that we are discussing and going to be discussed, some kind of intuitively saying over the last seven or eight years, some kind of mentally thinking about year 2000.  What is interesting is that most of these good developments in economic indicators happened not seven years ago, not even eight years ago, but almost 10 years ago.  The August ’98 crash has actually produced both economic growth that started on September of 1998, so that is why the economy entered the 10th consecutive year of quite impressive economic growth. 

Also, September ’98 should be considered as a turning point in fiscal policy, monetary policy, exchange rate policy, and all of the other policies that have been some kind of launched at least one year before Mr. Putin became prime minister, and one-and-a-half year before Mr. Putin became a President.  So I think it would be really helpful to keep in mind, this clarification now on our time horizon.

So now, I’m coming to my presentation also.  Since the topic is really not only relatively odd but rather intriguing, “What Is Wrong with the Russian Economy?”  And because some kind of explanation looks like it is only inflation should bother us.  Certainly, economy is likely wider than inflation and economic issues - why do then inflation issues?

There are some other issues that should attract our attention.  But we will not discuss all of them today, no doubt.  But since the words, “what is wrong with something in Russia” happens, so it was a great temptation for me to say something else what is wrong, but not only maybe with economy but also something that is related to economy - something that is related to both economy and society.

So that is why my presentation is divided in two parts.  One of them is devoted to inflation, precisely.  The other will be devoted to the issue that I call for myself the “Russia Puzzle.”  Certainly, it is not only Russia puzzle - but please excuse me for using this some kind of special name for this puzzle.

Okay, the part first is called “What’s Wrong with Russian Inflation?”  Let us start from the official estimates for inflation forecast and actual inflation; what we can have right now.  Two main producers of inflationary forecast are Ministry of Economic Development and Trade, and the Central Bank.  You can see these numbers for year 2007 with inflation forecast between seven and eight percent from the Ministry, and from 6.5 percent to eight percent from the Central Bank.  And you, by the way, can find those numbers still on the websites of these respectable and respected institutions.  For year 2008 - both of them - producing the same forecast, six to seven percent.

What is interesting that actual annual inflation not accumulated from January of the Russian Statistical Office accounting, still counting.  But if we look into annualized inflation in November 2007, it will be 11.6.  There is some kind of serious reason to expect that it could be maybe close to 12 percent annualized inflation in these months - December 2007.

And our question mark for year 2008 and there is once again, as usual, there is some kind of battle of forecast from officials and some kind of experts in what the inflation will be.  Interestingly, now that still some of the ministers, including the new minister of economy and some other officials, are even hinting that inflation next year will not exceed eight percent which, frankly speaking, looks quite unrealistic.  But nevertheless, let us look what is behind the inflation and what can be used as factors that can explain the recent spike in inflation.

Here, actually, I’m following the steps of Lachman, which is just some kind of annualized indices for inflation for consumer price index and for some other indicators like CPI, Core Inflation, cost of consumer minimum set and for fixed basket of basic consumer goods and services. 

It is not quite hard to see that at least three quite clear-cut ways of inflation tension of the last seven, eight years studied here from January 2000, on purpose, but just to see this.  We have more or less trend for inflation coming down but nevertheless these three waves of inflation which actually is very clearly seen here.

And we can see here there has been a spike in inflation.  For main inflation, it went from seven percent annualized in February-March 2007 to almost 12 percent in November 2007.  But interestingly now, that for cost of consumer minimum set, it jumped from two percent just in the beginning of this year to almost 22 percent in November.  It is the 10 times increase in annualized inflation, which is quite remarkable and certainly this is felt by many people in Russia.

So how can we explain this jump due to spike in inflation?  So if you are looking to the components of CPI, the main three components: from the food - green line; these non-food - yellow line; and services - some kind of blue line.  It is interesting that the non-food inflations are almost going down without almost any wave at all.  It is just, really, going almost strictly - there is some kind of following orders from the Ministry of Economic Development and the Central Bank.

Unlike food inflation, that really has some kind of rising, and services, inflation is not so much interested because it is largely still regulated at federal level or at regional level, so that is why it is much more difficult to make any conclusions based on the dynamics of the services.

At this, we can conclude that something really happens with food prices.  And exactly food was in the center of attention for government meetings and for discussion in the mass media over the last several months.  That is why the measures that have been proposed regardless of the camp in this discussion, we addressed mostly the food prices.  That is why the question will be whether it is just food exclusively or mostly, and so that is why it will be structural reason for this inflation or budget or monetary, also called macro economic reasons.

Let’s try to look into some of the pictures.

Here, there is some kind of indices for basic commodities on the world market.  Some kind of -- here also we can find fuel, energy.  Here - metals, non-fuel, All Commodity Index.  Food here, beverages - it means tea, cocoa, coffee, all these stuff - it is not Coca Cola - it is just different stuff.  And All Commodities Index is taken at 100 percent just to see how other indices can be compared with All Commodities Index.

And we can find that okay.  Energy, certainly, is clearly champion in this rise - no doubt.  Metals also are trying to be close to average for All Commodity Index.  But surprisingly enough, food is going down over the last eight or even nine years, and even the recent spike is not some kind of very visible.  Certainly, the last month is September but now European Union has removed their subsidies in spring and summer, so that is why even that act still did not have any serious impact on overall -- and that is for food prices.

So that is why we have to make some kind of preliminary conclusion that we should be probably slightly cautious in making only food responsible for recent spike in inflation.  And it could be just really, some kind of real structural reason because of some particular situation with the demand and surplus on this particular market and some particular other markets.  And we can see even in some neighboring countries including Ukraine and Kazakhstan, we do not see such or similar spikes in inflation like in Russia.

So what could be different reasons?  And here we have come to this some kind of very traditional, some kind of monetary paradigm, as Milton Friedman thought of inflation is always everywhere a monetary phenomenon.  So that is why we are looking to the annual indices of M2 and inflation with lags.  So these lags - I know that things are different and they are actually lengthening over time from 18 to 25 months and looks like it is, more or less, coinciding with what we have seen even in Russia in the ‘90s but with shorter lags.  And what we can see even in the United States - with a lag also close to two years.  So that is why, certainly, it is not the full corresponding in inflationary trends to what is going on with monetary trends.

Nevertheless, we can see that each wave in monetary growth causes some wave in inflationary growth, another wave of monetary expansion, another wave in inflation.  And now, we are just at the very beginning of another wave of monetary expansion and we are just seeing that inflation is going up.  So that is why probably we can make another very cautious conclusion.  It is a very cautious forecast that probably we could see at least sustaining the rate of inflation that we have already, about 12 percent annualized index, probably even higher, maybe up to 15 percent, and if some kind of colleagues at the Russian government would be very energetic in spending stabilization fund on these welfare projects that have been mentioned earlier.

So probably we will have inflation, annualized inflation even closer to 20 percent in the coming year or maybe a year and a half, at least - just expecting when this peak in monetary growth will be realized.

Okay, so what is important here is to see, what is the source of this monetary growth?  And here, if we look in some kind of international perspective, so we would find that Russia stands extremely high in almost every possible world ranking for monetary aggregates indicating that there is really some kind of monetary policy and fiscal policy, probably is not and not so good as we tend to believe.

Here, among 180 countries by annual CPI index, Russia is 21st.  If you look into the U.S. dollar prices inflation, Russia would be second in 180 countries.  In terms of increase in real effective exchange rate, in other words comparative prices - prices in Russia compared to prices in other countries and the rest of the world, Russia in the third place.  If you look into this annual broad money supply growth rates, Russia will be in the 9th place.  If you look into the budget balance - here, looks like it is really good because in 161 countries Russia occupies 13th place, which really somehow suggests that the fiscal policy is really very responsible.

But what is important to look - what countries are here before Russia - all of them almost without any exception, are all exporting countries:  Kuwait, Norway, Saudi Arabia, and many others.  Interesting that some of those countries have budget surplus at level – not some kind of, it is on average for these years - from ’98 to 2006.  Not on average as four percent of GDP like Russia here, but at level 10, 15, 20 or even 25 percent of GDP.

If you look in particular budget surplus in year 2006 and year 2007, probably we would be shocked and surprised in any other time - let’s say, 10 years ago, 15 years ago or 20 years ago - because many of those countries are running budget surplus at level 20 percent of GDP, 25, 30, 38 percent of GDP, and it becomes really some kind of a normal practice for some of those countries.  So that is why Russia with seven to eight percent of GDP with budget surplus, looks incredibly modest and, to use other words, rather weak in pursuing responsible fiscal policy compared to those all exporting countries.

We will recalculate this budget surplus and we will try to calculate Russia’s budget balance not for overall budget operations, not for all fiscal operation, but exclusively for non-oil and non-gas budget.  So it is with net of gas and oil incomes that is mainly due to terms of changes in prices in the world market, we would find that Russia occupies remarkable 133rd place among the 146 countries.

Fortunately, the Russian Minister of Finance, under guidance of Mr. Kudrin, started some time ago to calculate this non-oil and non-gas budget balance and to calculate how much of these oil and gas revenues would contribute to nation’s revenues.  And that is why they were actually courageous enough to announce that today the country has not a budget surplus, but budget deficits based on this non-oil, non-gas budget at level six percent of GDP.  And they foresee that the six percent of GDP would be sustained over course of at least several years and maybe even would increase.

So that is why probably this information allows us to have a slightly new look at the real level of fiscal situation in Russia, even with such incredible prices.  And the main reason for that, not so much even there is some kind of the budget surplus, which is some kind of sustained because on one hand, rising revenues, but on the other hand we have rising federal government non-interest expenditures that as a percentage of GDP almost doubled over the last eight years.  So that is a pretty remarkable speed with which expenditures are increased not only in real terms but also as a ratio to national economy.

So we can stop here with inflation because my main message is that probably we have partially structural impact on prices in terms of food.  But most important that we really have a very clear slippage in the macro-economic policy and fiscal policy that this pressure is not probably as visible as it was visible, let’s say, in the ‘90s because of this extraordinary situation with energy prices.  But nevertheless, the pressure is being built up.

Now, we are coming to the second part, which is called “What’s Wrong with Russian Society?”  It is a little bit some kind of pathetic, but nevertheless -- okay, what kind of puzzle -- the puzzle of so-called succession so to say, ended - at least some people believe that it has ended.  But then there is another puzzle.  A puzzle that I would call this puzzle of society, at least “Puzzle of Interplay between Economy and Society.”

So from the experience of many other countries and from historical example, we know about the very strong correlation between level of economic development, level of living standards and some kind of level of organization, level of education, and very important, levels of development of very important institutions.

Here, for example, the index here on the X we have GDP per capita, and here Economic Freedom Index constructed by Fraser Institute in Vancouver, Canada.  So it is a very clear positive correlation between these indicators.  Even more important and actually much more discussed, is the correlation between the level of economic development and democratic institutions.  Here, the political rights index.  The more a country is economically developed, the more it tends to be democratic, and more people tend to have political rights there.

Similarly, we can see with civil liberties the same story.  It looks like it has very clear correlations, huge literature has been written for centuries about that, that have been -- okay, here is another one - rule of law, also, very nice correlation between them.

So it has been written a lot about that.  One of the really most important but just there are certainly many more important pieces of literature exist on these, Seymour Lipset’s article of 1957 that it suggests - explained in the postwar era - Europe and Latin America most of all; and Francis Fukuyama End of History paradigm, that over the course of development, countries with high level of economic development tend to move to more democracy.  So that is why it allows Francis Fukuyama to call his very famous study as End of History.

And this approach became not only theoretical, but became also very practical.  In Russia a very substantial portion of policy have been built on this assumption: that stimulating the economic growth and creating best circumstance and best conditions for economic growth, we at the same time would help to develop institutions of a society, institution of state that will bring us closer to more sustainable level of democratic development.

So number of teams, different people, worked on that.  As a result, we noticed from 1998 Russian GDP has grown 85 percent and this year, finally, has reached the level of 1989.  No doubt, economy is growing.  Nobody is discussing.

But what is actually interesting and actually intriguing and provoking as a result, that we do not receive what we expected from theoretical studies and from our early expectations.  If you look on this let us say election falsification index that has been developed by one of my colleagues, who is writing in the Russian blogs under his name as you can see, he has developed this election falsification -- this certainly is heavily influenced by the latest parliamentary rigged elections on December 2nd.

As you can see -- so the elections under communist regime - here, the actual referendum 1991 was highly falsified.  After that, these presidential, parliamentary elections and referendum in ’93 was actually quite good because we have this negative correlation coefficient that means that the authorities did not have ballot stuffing.  So if somebody did it, it was opponents of authorities, but not authorities themselves.  Certainly, it probably does not fill the best criteria of democratic elections but at least authorities were not to be blamed for that.  But from ’99 to year 2007, we have a series of very weak and very falsified elections, actually with level of falsification rising further up.

So that is why we can construct such a picture that is correlational on some kind of the picture of GDP growth and election falsification list.  The high GDP, the more falsification - somebody could say.  Certainly, I would not say so, but at least we can construct such a picture.

And if you look in this some kind of independent observations by the Freedom House, they can see where the economic growth, electoral process index fell sharply, judicial framework and independence index - same; governance index - same; civil society index - same; independent media index - same; and overall index for civil liberties and political rights fell sharply as well over this period of time.

So that is why Russia’s deviation in actual index for civil liberties from the predicted one based on this model on GDP per capita became very, very serious.  The same story will be with deviation in political rights.

So instead of some kind of moving in the same direction, we do see that GDP growth, GDP index and civil liberties are moving in different directions, actually, in opposite directions for Russia, in a very clear contradiction to what has been predicted and what has been described and observed in many other countries, in many other cases.  And it is not only for those indices - let’s say, for violence, you hear these crimes against personality, some kind of the most heavy, most serious crimes, and we have a very substantial increase over the years when Russian economy was enjoying very serious economic growth and here it is almost full coincidence.

Certainly, it is not to say there is any science behind that but just to demonstrate that some traditional models and some traditional paradigms probably do not work completely or do work with some kind of deviations in the Russian case.  And here I cannot show this picture because here is a demonstration of something really extraordinary.

In 1996, political rights index in Russia fell lower than the world average; it was before that higher.  In the year 2000, lower than that of Sub-Saharan Africa.  In year 2005, lower than that of the Middle East.  They were the worst regions, a region in terms of political freedoms since 1972, when the Freedom House started to compile this information.  So the champion in the destruction of political freedoms and civil liberties now, not anymore Middle East, not anymore Arab countries, but Russia.  And it is really some kind of absolutely new picture and some kind of new phenomenon is developing here.

Whether Russia is alone in some kind of breaking in some kind of this rule, frankly speaking, not too many countries we can find in this group, but Russia is not alone.  One country is, in the form of Soviet Union, Azerbaijan - the same, some kind of the lines moving in opposite directions Kazakhstan and Venezuela, that is not in the form of Soviet Union but also some kind of moving in different directions.

What possible explanation can be produced for that?  And we know these possible explanations that have been put forward by many people with the concept of resource-curse, that oil should be blamed and all this additional rent that oil is produced.  Let’s look on some other countries.  Let us say Belarus.  How much oil Belarus have?  Zero.  Gas?  Zero.  Nothing.

Certainly, it can be claimed that, okay, Belarus is enjoying some subsidies from some kind of eastern neighbor - probably.  Okay, let us look in Pakistan.  At least, over the last 15 years, we have the same picture; let’s say sort of breaking the same rule.  What is even more interesting, especially for those people who are advocating resource-curse paradigm, this picture for indices of political freedom for 11 countries in OPEC and for USSR-Russia, for these 35, 36 years.  And we can see that in the period of this, let us say, ‘80s, when OPEC-11 then down, USSR and after that, Russia, then up very sharply.  So that is why having the same oil, same energy resources, and the same subsidies, different group of countries or different countries were moving in different directions.

And after that, in the last, again, maybe 12, 13 years, OPEC countries slowly, gradually but moving in the right direction, there is some kind of increasing the indices for political rights and civil liberties.  Not all of them, some of them faster, some others are slower, but they are moving in that direction.  Russia is moving in opposite direction.

These pictures just demonstrate that probably this resource-curse paradigm really does not have much substance and much proof.  So the situation looks like is much more complicated or it can help to do something but probably not everywhere and always.

Maybe my last slide here is other countries’ historical examples.  There will be twins - twins in two aspects.  In aspects of destruction of political institutions, of democratic society, not perfect - democratic society as Weimar republic was by 1933 as Russian republic was by 1999.  But for seven years - in both cases, seven years, Nazi Germany, GDP grew 60.8 percent.  Siloviki Russia grew 63.5 percent.  It is interesting that the rest of the world including liberal democracy and these countries like England, France, United States, they are growing much slower as it can be seen here - 29.9 and 29.2.  It is really some kind of remarkable similarity.

What is more important that this is a ratio between the growth in Nazi Germany over the rest of the world that is 2.4 times that makes -- and actually here, in Siloviki Russia compared to the rest of the world is the same 2.4 times.  And because it happens not only in one year, not only in two years, but already for eight years in a row with the same regime, it creates a special psychological feeling, not only among elites, but also spread it among a very wide strata of population that really, we have invented something special that probably does not work in some other countries, and that is why probably we are right - not moving in so-called traditional way that would lead us to the end of the history.

So that is why it seems to me - it is my conclusion - it looks like we are not yet close to the end of history.  Certainly, in terms of not only life but also theoretical debate and probably not too close to comprehensive and detailed understanding of what is going on.

Thank you.

Leon Aron:  Thank you both Desmond and Andrei.

I think we certainly laid quite a ground here.  We are very rich for debate and discussion.  So shall we start with comments and questions please?

Anders Aslund?

Anders:  Thank you very much both of you for very interesting presentations.

First, Andrei, I should say inflation is worse this year in Kazakhstan and Ukraine - both have reached 15 percent.  So what we are seeing here is not a singular Russian phenomenon; it is a regional phenomenon.  And also the rising food prices are taking up a lot of country and this late -- this circumvents my comment.

Two questions - first to Andrei about the stabilization fund.  Do you really think it is a good idea to have huge stabilization fund in a country like Russia with poor governance?  Of the countries that have a big sovereign wealth funds, only one is democratic: Norway.  Is a sovereign wealth fund something for dictators, like in Singapore, to reassure themselves for bad days in the future?  I think it is a bad idea, generally, at best you should try to avoid them and instead cut taxes as far as possible to reduce the bad stage.  I thought you would be in favor of that and not keep so much extra.  It sounds as if you want more than eight percent of the GDP in budget surplus, which sounds not a good idea to me.

And then, the other question to both of you, particularly to Desmond, what should be done about the excessive inflation in Russia today?

Thank you.

Leon Aron:  All right, we will start with Andrei.

Andrei, would you look to -- or Des, later.  Would you like to address the issue of the regionality versus specific Russian roots of inflation?

Andrei Illarionov:  I would like to answer the question that Anders has posed me on stabilization fund and I am really grateful to you that you raised this because we have too very clear few words even in my arguments and my views about stabilization fund.

One story was in year 2000, year 2001, year 2002, year 2003 when, from my point of view, there was no serious threat to institutional disintegration and rottening that we can observe right now.  And that is why at that time, I was advocating for stabilization fund.  Last two years, when I was an advisor, I was advocating for -- because already studied to be seen that this high energy price looks like not so much cyclical phenomena but more structural phenomena, and that is why to keep such high rate of taxation that would allow you to accumulate the resources on stabilization fund is not reasonable.  And that is why for the last two years, we were fighting with the government and the administration to cut taxes, and actually, to leave these institutional stabilization fund just for any case but just not to pour money there.

And over the last two years, probably, I don’t know whether you have seen those public articles that I have written on this issue, advocating exactly what you are saying - cut taxes.  And actually, virtually liquidate stabilization fund especially after some portion of the stabilization fund has been used to repay the debt.  So that is why there just no other macro economic reason and certainly there is no reason from some kind of political economy point of view and from an institutional point of view to keep such huge reserves in the stabilization fund - no doubt.  The best way is to cut taxes and to leave this money for private sector, for those people who would be able to use them more effectively than to be some kind of, to give for seal of the key and to squander them in their state corporations.

As for your second question, that is exactly the answer.  What should be done about that?  Actually, for some countries and Russia - actually, for all countries, inflation is impossible to eliminate fully.  And especially for countries who have a relatively low rate of monetization of the economy some level of inflation will be there for some time.  It just is impossible to bring them to zero in a short period of time.

But the other issue just to keep a higher budget surplus not by nine percent like some other energy exporting countries, and that is why cutting expenditures at a ratio of GDP - no doubt.  So it is just to do quite opposite to what is being done right now and is going to be implemented over a few coming years.

Desmond Lachman:  I just would say - just in relation to the question of sovereign wealth fund, not necessarily talking about the Russian context, but generally the idea of a sovereign wealth fund is to earn a higher rate of return on a country’s international reserves and it would be getting through a very conservative management of the international reserves, which are mainly held in short term United States or other major countries government bonds.  So the idea of a sovereign wealth fund is to try to go into more real investments or stuff that has got a higher rate of return. 

It might not be exactly the right moment to be starting this direction.  You might be looking at peak of the market, but from a longer-run point of view, sovereign wealth fund, I think, makes a lot of sense.  And I’m not sure that I would see that sovereign wealth fund lends itself necessarily to more corruption than a country holding high international reserves.

I would be cautious, though, about proposing cutting taxes to get rid of the surpluses that are being built up in stabilization funds; unless, they are accompanied by even greater expenditure cuts.  So what I would be really focusing on would be what is happening to the overall budget balance.  I would clearly not argue with the idea of getting a better overall balance, more through expenditure cuts rather than tax increases, and if you can do it through tax reductions and even greater expenditure cuts, that would be all the better.

If you allow the budget to deteriorate the way in which the Russians are doing, what you are doing is you are putting a very big burden on monetary policy.  So that would be the second point.  Monetary policy needs the flexibility.  Basically, what the Russians are doing is they hamstring, they cannot have any independent monetary policy with a fixed exchange rate because if what they do is they allow the budget to expand, they need high interest rates to offset it.  If they get high interest rates, that is just going to suck in capital flows one way or the other.  So it is self-defeating.

So my short answer is they basically need to be responsible on the budget side, and they need to be moving towards an independent monetary policy with a floating exchange rate.

Leon Aron:  Okay, please identify yourself, too.

Josh Handler:  Josh Handler, U.S. State Department.

I was wondering if you had any more details on the food inflation question.  Do you have any breakdowns on the basket of items when you looked at the price of the potatoes in various regions, price of cabbage, the basic elements of the Russian diet that has not changed too much over the last years, the price of the bottle of vodka, and who better understanding?  And what government policies maybe in place to mitigate those factors?

I mean, world grain prices are rising in general, so if you have any thoughts on that, if you can.

Desmond Lachman:  I’m afraid I have not gone into the entrails of the cost of living index.  What I would say is I’m rather surprised that one of the charts you put up just in terms of food price inflation because globally what we were having is we are having record wheat prices, record soy prices, record corn prices, a lot of these has got to do with energy prices and ethanol.  So I’m kind of a little surprised on that score.  You know, that what we are seeing is we are seeing wheat and soy at 30-year highs, which is exerting inflationary pressure even in this great land of ours, that we are getting food price inflation.  So I do not know how Russia is not suffering from grain inflation.  I thought that that was really what was driving the food basket in Russia.

Andrei Illarionov:  No, it is definitely what has been seen in the graph, which is exactly what you see there.  But if you will refer to the food index crisis, it is not for Russia, it is for the world.  This is world index for food prices compiled by the IMF, their data, according to which it does not look like we have any serious impact so far, at least as of September, year 2007.

Leon Aron:  All right.  I think there were -- yes, out there please.

Rick Leeds:  Thank you.  Rick Leeds [phonetic], Fairfax.

What do you guys think about, as far as lowering the international oil price, a U.S., revenue neutral, increased oil - not carbon per se but just oil decreased payroll tax?

Leon Aron:  Where?  In the United States?

Rick Leeds:  Yeah.

Leon Aron:  Okay.

Desmond Lachman:  Yeah, your proposal is a proposal that many economists have pictured for many years because basically, what we are doing, is we are allowing the proceeds of the tax to go to OPEC and countries that we might not be that friendly with.  So it is a very sound idea to raise taxes on energy and do it in a neutral way so that it would not be a tax increase.  What you would be doing is you would be reducing payroll taxes elsewhere.

There is just a slight problem about an oil lobby and stuff of that sort that would make sure that that does not happen.  But the idea, intellectually, I think is sound and you would not find many serious economists, unless they are on the payroll of the oil lobby, opposing that.

Leon Aron:  It looks like you are just –- sorry [audio skip] -- it is coming.

Horst Freitag:  Thank you.  I’m Horst Freitag from the Brookings Institution.

I think it was recently Gaidar who said that in order to keep the purchasing power of all the pensions stable as they are right now, all of the amount over the next couple of years - and I think by couple, he meant two or three years - the whole amount of the stabilization fund would be needed.  Is that something that you could comment on?  Number one.  And number two - there is an idea about splitting up the stabilization fund in two different funds and I wondered if you have some thoughts on this?

Thank you.

Andrei Illarionov:  I think it is a bad idea.  I think it is a very bad idea - both.  But first, it is certainly the worst idea and we had a very intensive debate about that in Russia.  I think it is even worse than to keep the stabilization fund in the form that they should not be spent.  Because in this case, the idea of stabilization fund to accumulate resources that should not be spent within the economy; that should not be spent domestically just to avoid additional inflationary rate pressure within the economy.

So regardless what kind of expenditure will be - infrastructure, military, social expenditure - whatever, if they are spent within the country, so they have the same effect.  The same monetary effect with the rising prices unless raising a real exchange rate with all of those consequences.  So that is why they suggest to kill stabilization fund right away, but it is not only that bad idea.

Unfortunately, it has another bad side because in this case, the quite unreformed and to very high extent the still communist pension system would be backed by these new resources.  Instead of some kind of reforming these pension system and creating really, a new competitive and private pension system, this idea would actually prolong existence of the pension system that has not been reformed neither by Gaidar himself when he was in the government nor by any consecutive governance over the last 17 years, so that is why this is really a very bad idea.

Unfortunately, our government is very well known for picking up very bad ideas and implement them, so that is why unlike many other ideas of Gaidar that they ignored, they picked up this idea, and they established this some kind of fund that originally was aimed to use those resources on pension fund.  Probably, they completely did not bury this idea.  Probably, they will come back to that, but unfortunately, a number of bad ideas look like are able to survive for a long, long time.

Horst Freitag:  Just a clarification, I just meant to draw your attention on the dimension of the problem, it was not Gaidar suggesting to do so, but just to -- he just said that, that much money was needed.  So just to clarify, it was not Gaidar suggesting to do so.

Andrei Illarionov:  No, no.  It is exactly Gaidar who was suggesting that because he has been writing extensively on this issue.  He has been publishing now maybe some three dozen articles in Russia over the last two years suggesting exactly what you have described, including putting these pieces even in his book, Death of the Empire, that he has presented here, some kind of the short -- in the very short form, but he went at length explaining and arguing for that and it is exactly some kind of piece of the documentation that has been produced by the Institute for the Economy in Transition - his institute - to the government, and the government actually has picked up and is using.

Leon Aron:  Okay.

Well, I think, we have -- I do not know, we did not put them to sleep but were just intellectually dazzled.  I mean, they are incapable to produce --

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