Shock Therapy and the Russian War on Ukraine

Columbia University economist Jeffrey Sachs writes in today’s Financial Times, ““Kindly note that the US neoconservatives (with plenty of enthusiastic support from the UK) are doing their bit to destroy Ukraine. By pushing relentlessly for NATO’s eventual enlargement to Ukraine, and for escalation rather than negotiations, the neoconservatives are exposing once again their recklessness and heedlessness. The US role in Ukraine’s destabilization is an old, sad, and oft-repeated story of US foreign policy, recalling the US role in destabilizing Iran, Congo (today’s DRC), Vietnam, Cambodia, Laos, Afghanistan, Iraq, Syria, Libya, Serbia and Venezuela, to name just a few cases.”

With this he joins his voice to the chorus that blames Russia’s invasion of Ukraine on NATO expansionism, by which he really means American expansionism, since by his calculation the other members of NATO are nothing more than American puppets.

Given his experience as the inventor of the “shock therapy” – “rapidly unleashing market forces [as] the way to electrocute the old Soviet system and jolt Russia into embracing capitalism”, Dr. Sachs should know better. After all, Dr. Sachs, who became a tenured Harvard professor of economics at the age of 28, gained his notoriety “selling himself as an advisor to struggling governments dealing with crises of hyperinflation, a topic about which Sachs boldly claimed to know ‘just about everything that is needed to be known’.”

Dr. Sachs first experimented with shock therapy in Bolivia, where he landed in 1985 at the invitation of the country’s Prime Minister. Bolivia was experiencing 23,000% annual inflation. Its foreign debt of $4.6 billion was more than its GDP and the country was in arrears on its payments to the International Monetary Fund (IMF). Something needed to be done. That something was Supreme Decree 21060, enacted in August 1985.  The decree dismantled fixed exchange rates and allowed the Bolivian peso to float freely against the U.S. dollar, which caused it to lose 93% of its value overnight. Price controls and subsidies for basic commodities were abolished immediately, causing the price of a liter of gasoline to jump 7.5 times. Two-thirds of the employees of state-owned corporations like the tin and oil companies were fired and salaries were reduced for those who remained. Other state-owned enterprises were dismantled or sold to private investors. The unemployment rate soared to 21%. Inflation did fall to around 11% by 1987, but otherwise it is hard to characterize the therapy as a success.

In fairness, though, from the mid 2000s to the present Bolivia cut its poverty rate in half, doubled its per capita GDP, and brought inflation down to around 3%. However, the 20-year lag between administration of Dr. Sachs’s remedies and these promising results would seem to rule out shock therapy as the cause, though Dr. Sachs might claim otherwise.

Poland is pointed to (especially by Dr. Sachs) as another victory for shock therapy, but as Nobel prizewinning economist Joseph Stiglitz points out, “Poland is one of the most interesting cases, because it did use shock therapy to get inflation down. And some people think, therefore, it is a shock therapy country. But that's not right. In fact, what it did was to have gotten inflation down to reasonable levels, and by that, I mean 15-20 percent a year, not to the very, very low level. It didn't pursue getting inflation down with a single-mindedness that was the case in some of the other countries. It then took a gradualist policy of restructuring their economy, restructuring their society. And the result of that was the best performance, relative to where they were in the beginning of the transition. So there were alternatives, those who chose the alternatives were more successful than those who chose the shock therapy.”  

Stiglitz also points to Slovenia and China as successful examples of a gradualist approach: “First of all, they focused on creating new enterprises rather than just restructuring the old. They focused on creating jobs and employment. So as you restructured the old, you had new avenues to use society's resources. Moving resources from low productivity to unemployment doesn't increase societies' wealth, doesn't increase anybody's income. Moving resources from low productivity to high productivity does. But if you have tight monetary policy that has interest rates at 25, 50, 100, 150 percent [necessary to stifle inflation in a hurry], you can't start new businesses. And if you can't start new businesses, how are you going to have the new enterprises that are going to create the new jobs? As you are re-orienting the economy, you take out the resources from the inefficient sector to move into the more efficient sectors.”

Which brings us to Russia, where Dr. Sachs, holding court in the opulent lobby of Moscow’s Metropole Hotel, set the course for that country’s therapy. There is no doubt that Russia’s economy was in dire shape, with annual inflation of more than 2,500%.

However, from the launch of the shock therapy program in January 1992 to 1997, Russia’s GDP went down 83%. Agricultural production dropped 63%. Investment declined 92%. 70,000 factories were shut down, causing a massive drop in industrial production and loss of 13 million jobs. Wages for those still in employment dropped 50%, while the average male lifespan fell by six years, something rarely seen in the absence of war, famine, or pandemic.

Stiglitz again: “At one point [Russian] interest rates were over fifty, a hundred, and up to 150 percent. How could you have job creation? That was called a stabilization policy, but it wasn't stabilizing the society, it was actually leading to these policies that in some sense led to the implosion of the society, the economy and a destabilization of society.”

The social consequences of Russia’s shock therapy were arguably worse and longer lasting than the economic ones. To replace the command economy with a free market, Russian policy makers and their advisors embarked on a massive program of privatization. Almost everything – apartments, shops, factories, farms, mines – was offered up for sale. Of several models of privatization, Russia chose the quickest. Based on the model employed in the Czech Republic, each of Russia’s 140 million citizens was granted the right to pay 25 rubles (less than a penny in dollar terms) for a privatization voucher with a face value of 10,000 rubles, that could be exchanged for shares in enterprises, sold or donated. One critical difference:  in the Czech Republic, vouchers were inscribed with the holder’s name, but, in Russia, this was not the case. So while some people were exchanging their vouchers for shares companies being privatized, others were selling them to middlemen or exchanging them for food, vodka or household appliances.

This led to creation of the mafia state that Russia became. Soviet-era directors of factories and collective farms now being privatized forced their employees to turn over their vouchers under the threat of withholding their salaries. When the new owners proved incapable of running their enterprises in a market economy, the assets were snapped up by financial concerns which had set up voucher funds and banks. With these funds they were able to buy companies at fire sale prices or extend loans to state-owned companies and, when the companies defaulted on their loans, take title to them. This is how almost all the oligarchs made their fortunes. Forbes in 2012 estimated that over two-thirds of Russia’s dollar billionaires had made their fortunes through the privatization process.

So how does this relate to Russia’s invasion of Ukraine, the NATO response, and the other American misadventures Dr. Sachs mentions? As a 1998 publication by the Wilson Center, a think tank, puts it:

“In every case since 1985, when it was first employed in Bolivia, shock therapy has caused either major constitutional changes or declarations of states of emergency that suspended normal democratic procedures, where it resembles more of a revolutionary than a legal process. It can fundamentally alter the nature of the political system in new democracies. This fact has often been ignored, even though it raises serious questions about shock therapy's relation to the rule of law. In Bolivia, Peru, and Argentina, shock therapy was implemented by neutralizing parliamentary bodies with uses of presidential decree, martial law, and changed constitutions enhancing presidential powers.”

The calamitous results of shock therapy in Russia were not the consequence of deliberate American policy. In fairness, Jeffrey Sachs recommended that the therapy be accompanied by substantial debt relief and creation of a $30 billion fund to help Russia through its painful transition, a recommendation the U.S. government and international financial institutions ignored.

There is nothing wrong with restructuring or privatizing state-owned enterprises, liberalizing foreign exchange, and reducing or eliminating consumer or corporate subsidies. But there is a right way and a wrong way to do these things and Jeffrey Sachs, for the most part, has advocated the wrong way. In my career I have worked on these themes in quite a few countries, including Poland and Kazakhstan, neither of which opted for full-on shock therapy and both of which emerged stronger than they would have otherwise.

Let’s finish by setting the record straight on Dr. Sachs’s accusations regarding the war in Ukraine.

First, blaming the neoconservatives seems odd, since neoconservatism arose in the 1970s and mostly withered away around the time in 2005 that Paul Wolfowitz left the Bush Administration to become President of the World Bank, the neoconservative project of remaking Iraq in America’s image having proved a catastrophic failure.

Second, there has been no relentless push to admit Ukraine to NATO. There was certainly no talk of it prior to Russia’s invasion, and even now the most that any NATO country or official has been willing to allow is the possibility of an eventual invitation at some point once hostilities have ceased and on compliance with various undefined conditions.  Indeed, President Zelensky has complained about the lack of an invitation or a timeframe for admission.

Blaming Russia’s invasion of Ukraine on America and its NATO allies is based on a 1990 verbal promise by U.S. Secretary of State James Baker, which never made it into a written agreement, that NATO would not expand into the newly liberated countries of Eastern and Central Europe in exchange for allowing German reunification. I was ambivalent about the subsequent admission of new NATO members. But as Putin, a former KGB man, consolidated his power and embarked on expansionist adventures (e.g., the invasion of Georgia on the pretext of protecting Russian-speaking minorities) many of those countries felt threatened and sought protection in the NATO alliance.

For the past few decades, most of Russia’s neighbors have had cause to feel threatened. Kazakhstan moved its capital from the southern city of Almaty to Astana in the north, at least partly to dissuade Russia from seizing part of its territory. While working in far Western Kazakhstan, around the time of Russia’s annexation of Crimea, I asked a friend why Kazakhstan did not try to build an oil pipeline to Europe which would bypass Russia. His response: “The day we announce that project is the day Russia invades us.”

There is also the matter of the Budapest Memorandum. When the Soviet Union broke up, Ukraine was suddenly in possession of the world’s third-largest nuclear arsenal. Ukraine, along with Kazakhstan and Belarus, were happy to get rid of their nukes but sought security guarantees. In Budapest in1994 the three countries formally acceded to the nuclear nonproliferation treaty and signed memoranda with the Russian Federation, the United Kingdom and the United States which prevented them from threatening or using military force or economic coercion against Ukraine, Belarus, and Kazakhstan, "except in self-defense or otherwise in accordance with the Charter of the United Nations." Putin has tried to sell the idea that his invasion of Ukraine is a war of self-defense, but we know that is a delusion or a lie.

Apart from former President Trump’s famous phone call to President Zelensky, it is hard to see how the United States has destabilized or tried to destabilize Ukraine. If anything, we have been overly cautious in our support, equivocating over provision of every incremental weapon system, tank, or aircraft, in large part due to concern about direct military engagement with Russia. It is even possible that the American people and the U.S. Government have learned something from past misadventures in Indochina, Africa, Iraq, Afghanistan, Libya, and elsewhere.

His record in Bolivia, Russia, and elsewhere shows that Jeffrey Sachs did not, in fact, know just about everything that is needed to be known about how to fix hyperinflation and crushing debt or to restructure an entire economy. There is no evidence that he knows just about everything that is needed to be known about U.S. foreign policy and Russia’s war in Ukraine, or indeed anything at all.