THE CRISIS IN THE RUSSIAN ECONOMY

Vitaly V. Shlykov

June 30, 1997
ii

*******

The views expressed in this report are those of

the author and do not necessarily reflect the official

policy or position of the Department of the Army, the

Department of Defense, or the U.S. Government. This

report is cleared for public release; distribution is

unlimited.

*******

Comments pertaining to this monograph are invited

and should be forwarded to: Director, Strategic Studies

Institute, U.S. Army War College, Carlisle Barracks, PA

17013-5244. Comments also may be conveyed directly to

the Conference Organizer, Dr. Earl H. Tilford, Jr., by

calling commercial (717) 245-4086 or DSN 242-4086.

Copies of this report may be obtained from the

Publications and Production Office by calling

commercial (717) 245-4133, DSN 242-4133, FAX (717) 245-

3820, or via the Internet at rummelr@carlisleemh2.army.mil

*******

This monograph was originally presented at the

U.S. Army War College's Annual Strategy Conference held

April 22-24, 1997. The Strategic Studies Institute is

pleased to publish the paper as part of its Conference

Series.

*******

All 1995 and later Strategic Studies Institute

(SSI) monographs are available on the Strategic Studies

Institute Homepage for electronic dissemination. SSI's

Homepage address is: http://carlisle-www.army.

mil/usassi/
iii

FOREWORD

The words, from the 1970s ballad, "Me and Bobby

McGee," "Freedom's just another word for nothin' left

to lose..." might apply to the terrible state of the

Russian economy and, by extension, Russia's armed

forces. Since the Soviet Union crumbled in 1991 and the

Russian government set the country on its shaky journey

toward capitalism and democracy, the Russian economy

has been in a downward spiral; one which has drawn a

majority of Russians into poverty and even lowered the

average life expectancy by some 10 percent. To provide

some scale for comprehending the magnitude of this

problem, the more than 1.5 million men and women in

uniform in the Russian armed forces and the 600,000

civilian employees of the Ministry of Defense, as well

as the several million military pensioners throughout

the land, must share a total defense budget of $15-$18

billion per year. That is about one-fourth of the U.S.

Army's budget.

The paper that follows, by retired Soviet Army

Colonel Vitaly Shlykov, is a brutally honest appraisal

of the harsh realities that are a part of today's

Russia. It was presented at the Army War College's

Eighth Annual Strategy Conference, "Russia's Future as

a World Power," held at Carlisle Barracks,

Pennsylvania, April 22-24, 1997. Colonel Shlykov's

paper is even more sobering when one considers that the

October Revolution of 1917 began in the bread lines of

Petrograd and Moscow.

RICHARD H. WITHERSPOON

Colonel, U.S. Army

Director, Strategic Studies

Institute
iv

BIOGRAPHICAL SKETCH OF THE AUTHOR

VITALY V. SHLYKOV retired from the Soviet Army in 1988

at the rank of colonel. During his 30 years of service,

Dr. Shlykov was a research analyst in the field of

defense economics. He also served on the General Staff.

He earned his Ph.D. at the Moscow Institute of Foreign

Relations and is a graduate of the Military Diplomatic

Academy. After retiring from active duty, Dr. Shlykov

spent 2 years as a senior research fellow at the

Institute of World Economy and International Relations

in Moscow. From 1990 to August 1992 he was the Deputy

Chairman of the State Committee on Defense in Russia.

He is an acknowledged expert on the Russian defense

industry and its associated budget.
1

THE CRISIS IN THE RUSSIAN ECONOMY

It seems as if the universal laws of economics do

not apply to Russia. According to the economic theory,

in the period of transition from a rigidly centralized

economy to free market, prices are not set, state-owned

businesses are privatized, and then there is a phase--2

or 3 years long--of painful adjustment and rising

unemployment. After that--and this has been happening

in Poland, Hungary, the Czech Republic, and the Baltic

states--the economy starts growing.

Russia freed prices on January 2, 1992. It

privatized tens of thousands of enterprises, stabilized

the ruble, and wrung inflation out of its economy. In

1996 the government squeezed inflation to a manageable

21.8 percent, the lowest since the start of reforms and

down sharply from 133 percent in 1995. The monthly

inflation rate fell steadily through 1996, sinking to

1.4 percent in December from 4.1 percent in January.

Now it has been more than 5 years since the collapse of

the Soviet Union, but statistics show a continuous,

Great Depression-scale contraction (approximately 50

percent since 1991). In 1996 gross domestic product

(GDP) was 6 percent lower than a year earlier.

Industrial output has fallen 5 percent for the year,

worse than the 3 percent decline in 1995.

Russia's First Deputy Prime Minister, Viktor

Ilyushin, has released statistics indicating that,

contrary to much of what the government has been

saying, each consequent year of reforms continues to

pull people into poverty. Characterizing the situation

in Russia's social sector as "catastrophic," Ilyushin

said that real incomes are now 40 percent lower than

they were just 5 years ago. In January 1997 the

subsistence level was 394,000 rubles per person ($70) a

month, with 22.4 percent of Russians (about 33 million)

earning below that level. A full 75 percent of that 

total--R290,000--just covers the monthly food basket of

25 dietary essentials such as eggs, bread, flour, and

milk. The balance covers costs associated with housing,
2

transport, medicines, and clothing. Average per capita

incomes were 111 percent above the subsistence level

(R829,600, or $150). The country's top 10 percent of

wage earners had 12.8 times more income than the bottom

10 percent. Only 7.3 million, or 4.9 percent of the

population, earned more than 2 million rubles per

month.

The State Statistics Committee also reported wage

arrears totaling 48.6 trillion rubles as of January 27,

1997, a 3 percent rise on the previous 5 weeks. Budget

shortfalls accounted for 19.5 percent of arrears, while

money shortages at companies and other organizations

made up the remaining 80 percent. Russian industry

workers are owed 22.93 trillion rubles in back wages,

with 1.044 trillion rubles of that owed by federal and

local budgets, and 21.886 trillion rubles owed by

companies themselves. Life expectancy has plunged to

its lowest in 15 years. According to the World Health

Organization in Geneva, the average Russian man can

expect to live 57.4 years, compared to 61.1 years in

1981 and nearly 64 years before Mikhail Gorbachev

stepped down and President Boris Yeltsin started

Russia's transition to capitalism.

Russia's disastrous economic situation seems on

the surface like a social explosion waiting to happen.

And indeed, in two of the largest walkouts since the

Soviet collapse, coal miners and the Far East energy

workers staged huge strikes last year that ended only

when the government came up with hundreds of billions

of rubles in back wages. And yet despite a steep drop

in living standards and a dramatic worsening of the

problem of unpaid wages, the rumble of protest has yet

to turn into a unified roar--the kind that could stir

mass action and perhaps force changes in economic

policy.

Many experts, both Russian and Western, express

puzzlement over how a significant segment of the work

force can go without pay for up to 6 months. Among the

possible reasons, they say, are union disarray, fear of
3

unemployment, a national psyche not fully geared to

striking, and, finally, the renowned stoicism of the

Russians. Yet, in the land of the original Potemkin

village, rarely is anything as it seems.

In Russia, where most firms play down success for

fear of paying taxes, poor output figures often hide a

booming black market economy. Official figures,

reassessed after the World Bank complaints that Russian

statisticians were ignoring the black market economy,

indicate that it accounts for 22 percent of GDP. But

even Prime Minister Chernomyrdin admits that the size

of the untaxed shadow economy might be as high as 50

percent of GDP. The Russian Ministry of Economics even

refuses to believe the data of the State Statistical

Committee about decline of the Russian economy in 1996

and insists that there was no fall in GDP or industrial

production last year. As proof, it cites the official 

statistical data, according to which the electricity

output, which cannot be easily hidden, actually grew in

1996.

The fact that from one-quarter to one-half of

Russia's GDP is hidden from the authorities probably

explains why there is no widespread hunger, even though

large swathes of the population have not received

salaries for months. There is also a big difference

between average salary and average income level of a

Russian citizen. Every business either keeps two books

or has other ways of compensating its workers because

of the obvious impossibility of providing for a family

on an average salary or even on two average salaries.

The shadow economy means that the economic pie is

larger than the official statistics would suggest.

Signs of conspicuous consumption of wealth can be

seen in all the large Russian cities. New modern

buildings are being constructed, old buildings are

being lavishly restored, and the so-called "New

Russians," that is, people with large fortunes, race

around in their BMWs and designer clothes. The majority

of these individuals, with their pompous mansions and
4

expensive cars, successfully avoid paying taxes. On the

other hand, the new "money elite" throws its money

around. No one is rushing forward to announce himself

the owner of a large fortune by giving the government,

society, and the media real figures on the sources of

that wealth. And this is probably not just because of

the criminal or semi-criminal origin of much wealth,

but because, for now, such are the "rules of the game"

established by the government.

The separation of the "New Russians" into a

special social class is connected not so much with

their role in the organization of modern industry and

in the effective management of the national economy as

it is with the process of acquiring and distributing

wealth, with the status and prestige of consuming.

Market and banking activities, profitable import-export

operations, the use of privatized property by either

selling or renting, the apportioning to themselves of

huge deposits and "dividends"--these are the main

sources of the quick separation of Russian society into

the "money elite" and the "average Joes." All of this

only leads to the growth of alienation between the

disparate social groups. It creates the danger that

Russian society will be polarized and unstable, with

great potential for unrest and conflict.

There are signs that Russians' resources for

getting by have been largely exhausted. The

government's strict monetary policy, intended to tame

inflation, has been squeezing state coffers and causing

unpaid wages and pensions to skyrocket. Overdue wages

and social benefits have more than tripled in a year to

about 40 trillion rubles ($7 billion). Workers

sometimes get their pay in shoddy or basic goods.

Enterprises across Russia offer employees candy,

cement, coats, vodka, and even cigarette lighters and

brassieres imported from China.

The picture of the Russian economy painted even by

the top-level officials in the Russian government is

striking both for its blackness and its candor. Deputy
5

Prime Minister Ilyushin said that Moscow might adopt

inflationary policies that "might not please certain

international monetary organizations." At the end of

1996, Economics Minister Yevgueny Yasin wrote in a

letter to Prime Minister Viktor Chernomyrdin that "if

existing trends in the economy are continued without

energetic and purposeful efforts to break them and

create real conditions for economic growth, the

situation will in all probability continue to get

worse." He said that the 1997 budget was completely

unrealistic and that revenue forecasts should be scaled

down, and both social and defense spending had to be

cut, even if this increased the risk of political

unrest. But Yasin's warnings were not heeded. The

government pushed through the State Duma a budget for

1997 that no one believes to be even slightly

realistic. Consider these basic numbers: The 1997

budget pledges to raise spending to 19.4 percent of

GDP, whereas last year's spending ran at only 15.4

percent of GDP. The budget allows that 3.5 percent of

the whole will be filled by borrowing, but the rest

must come from taxes. In other words, Russia must

collect taxes worth 15.9 percent of its GDP.

Everyone admits that this is impossible. Last

year, according to the State Statistics Committee,

Russia could only raise revenue equal to 11.1 percent

of the GDP from taxes. In fact, the budget offers few

clues on how revenues are to be boosted by a hefty 4.5

percent of GDP. The point is that no one, not even

those closest to the process, believes that the

budget's rosy predictions of a huge boost in spending

financed by massive growth in government revenues are

real. "Only 70 to 80 percent of the things in the

budget will ever happen," said Mikhail Zadornov, head

of the Duma's budget committee. Sergei Dubinin,

chairman of the Central Bank, said the figures are so

wrong that the government will have to cut spending by

60 to 130 trillion rubles this year to compensate.

Well then, what lies behind this elaborate smoke

and mirror game if the numbers are all nonsense? The
6

confusion is a sign that a budget in Russia is

something very different in purpose from its Western

counterparts. In other countries, the budget is a real

plan for the national household for the next 12 months.

In Russia, the budget has emerged as something like a

statement of good intentions. For the government, the

real purpose of the budget is not so much to win

detailed approval of its spending plan but to win a

mandate to continue fighting inflation and containing

the budget deficit. A formal budget bill is necessary

for the government to secure International Monetary

Fund support for the continuation of its 3-year $10.1

billion loan agreement.

The good news for the government is that it has

more or less won. The new budget incorporates its low

inflation target of 11.8 percent for 1997, backed by a

relatively low deficit projection of only 3.5 percent

of GDP. From the government's point of view, everything

else in the budget will take second place to meeting

its monetary targets. So in order to hold the line on

the deficit and inflation, spending will have to be

slashed.

That is what happened last year. The government

promised to spend a lavish 18.9 percent of GDP, funded

by 15.1 percent in revenue. In fact, revenue collapsed

to 11.1 percent, but the government slashed spending to

only 14.4 percent. All the numbers in the budget were

skewed except for one: the government still met its

target of keeping the budget deficit around 3 to 4

percent. Having accepted that the budget is about

setting low inflation and budget deficit targets and

that spending predictions are just serendipity, the

rest of the budget process becomes understandable,

albeit rather comic.

Only about one-third of the budget, including

spending on education, wages, food, and medicine for

the army, and interest on government debt, has been

listed as so-called protected items that will receive

priority financing. According to the law, if the
7

quarterly revenue collection falls below 90 percent of

the projected amount, the government is supposed to

present parliament with a bill that outlines

proportional cuts on all spending items apart from the

protected items. This will probably wipe out investment

spending as well as other crucial items such as

subsidies to the pension fund and local governments.

Russia's fairy tale budgets have been allowing

politicians to avoid responsibility so far for the nonpayments crisis in the country because, in Russia,

parallel to the official state budget there exists the

so-called quasi-budget sector that includes the huge

pension fund, the road fund, and the local budgets.

When this wider definition is taken into account,

Russia's government spending rises from 14 to 38

percent of GDP. When, in January 1997, about one-tenth

of Russia's 4.5 million teachers went on strike to

protest overdue wages (some teachers have not been paid

for 8 months), the government simply blamed local

officials for the problem. The difficulties the local

governments face in financing their needs are enormous.

Two-thirds of the housing costs in Russia are still

assumed by the state. Russians spend only a small

percentage of their family income on electricity,

heating, and building maintenance. If all the budget

expenditures on housing are added together, one arrives

at the astronomical figure of 103 trillion rubles

($18.2 billion). This is exactly the size of the

Russian defense budget for 1997. For education and

health, the local governments also spend approximately

100 trillion rubles a year.

Simple estimates show that if housing, education,

and health reforms are not carried out any time soon,

building maintenance and other subsidies will simply

eat up the Russian economy. There are signs that the

government seems to understand this. Speaking at the

World Economic Forum in Davos at the end of January

1997, Economics Minister Yevgueny Yasin stated that

Russia was faced with disaster unless it cut spending

by about a third in the next 3 years. "If we fail, we
8

will be faced with the prospect of an extended

depression. Russia has probably more social dependents

than any other country, with the possible exception of

Sweden. We want to build a capitalist market economy

with a socialist system of social security," he said.

The problem is that strong political will is needed to

carry out such reforms. Only a president who will not

be running for the next election can carry out the

needed reforms. Whether President Boris Yeltsin will

decide to do so, however, is another matter.

Yeltsin and the government seem to be preoccupied

with more immediate problems. The fact that government

revenues remain catastrophically low (60 percent of

that planned in 1996) has apparently forced the

government to declare war on tax evaders. Russians have

had a field day with the president's decision to form

in October 1996 a "Temporary Extraordinary Commission"-

-called Vcheka (nicknamed from a contraction of three

Cyrillic letters in its unwieldy full title)--using

their wits to keep fighting the war on taxes. The

commission has the same initials as a secret police

organization that Lenin established in 1917 to spread

state terror. The name stuck and, even as the Vcheka

(or Cheka for short) mutated over the years into the

KGB, Soviet citizens continued to refer to it in

fearful whispers as the Cheka. The choice of this name

was no accident. Tax evasion is a national sport in

Russia, and any worker can cite examples of how his

enterprise or organization has managed to evade taxes.

So the naming of the tax commission Vcheka was a

flamboyant propaganda play to show that the government

was serious about collecting taxes.

But it will probably be just a case of much heat

with little light. So far, the Vcheka's major move has

been to fire a middle-rank customs official and to

start bankruptcy proceedings against four companies

which owe only a small fraction of the overall

corporate tax arrears. No move has yet been made

against the really serious tax evaders that enjoy

political favor--like Gazprom, the gas conglomerate
9

once run by Chernomyrdin. Such cronyism causes most

Russians to dismiss the new tax war as nothing but

power-mongering inside the Kremlin. To many observers,

the Vcheka is an instrument of Yeltsin's chief of staff

Anatoly Chubais--crafted not merely to tame the

financial bedlam, but to strengthen his own power.

While any of the above-mentioned measures would be

a step in the right direction, the single most useful

action the government could take to increase the

catastrophically low state revenues would be a genuine

overhaul of Russia's tax system. The existing tax

system--if it can be called a system--is made up of

1,200 poorly coordinated or utterly contradictory

presidential decrees, government orders, and

ministerial instructions. Moreover, there are about

another 3,000 legislative and sub-legislative acts that

indirectly refer to tax norms. Thus, the more than

4,000 such acts regulate about 20 various taxes. Even

the representatives of the tax service are not always

able to figure them all out. As for taxpayers, almost

anyone can be accused of violating one of the 4,000 tax

documents. The debt of taxpayers to the budget is

steadily growing. Last year, the sum of taxes that was

owed was more than twice the 1995 level. Companies and

individuals are not the only tax debtors. Of the 89

subjects of the Russian Federation, only three have

fully paid their debt to the federal budget.

Furthermore, seven out of the 89 regions provide almost

52 percent of the budget's revenues, with Moscow

accounting for 27 percent.

On February 20, 1997, the government considered

for the first time the draft of a new tax code, which

the Finance Ministry has been working on for years. The

idea behind the tax code is to put order into this

contradictory and often inscrutable tax system in

Russia, limit arbitrary rule by officials, and decrease

the opportunities for legally and illegally evading

taxes. The tax code proposes to simplify the existing

system. It would reduce the number of taxes from 200 to

30. The code also is aimed at making fundamental
10

changes in tax exemptions. While working on the new tax

code, the Finance Ministry uncovered an astronomical

number of tax exemptions acquired at various times by

various means. The level of lost budget revenues

because of these exemptions is estimated by the Finance

Ministry at 160-170 trillion rubles a year.

The task of taking away exemptions is a formidable

one. Any government which really intends to halt this

gravy train will face fierce resistance from an army of

special interests and their parliamentary sponsors (for

instance, removing the tax privileges from the

thousands of generals and hundreds of thousands of

officers in the Russian army, who are exempt from

paying income tax). The tax police, who are there to

catch tax evaders, are exempt from income tax. Even in

the government itself, the Finance Ministry has hardly

any allies with its new tax code. Many ministers openly

and secretly fight to keep their existing privileges--

and not without some success. The tax code, which the

government looked at when it convened on February 20,

was not sent to the State Duma, as the Finance Ministry

had hoped, but was sent back to be reworked. The

chances of the new tax code being passed by the present

Duma are extremely slim. Compared with what the holders

of tax privileges stand to lose, dismissing the finance

minister or the government itself, which are trying to

abolish these exemptions, would be a very small price

to pay.

But what really makes the attempts of the present

government to improve the economic situation futile is

the beginning disintegration of the Russian military

machine. In only a few years the military force that

held most of the world in terror has been plunged into

penury and humiliation, for the most part by its own

government. The government seems totally incapable of

solving the financial problems of the military.

The errors that were permitted during the

development of Russian military budgets were so

elementary for any competent economist that it is
11

awkward to talk about them. First, the rapid coming

together of the purchasing power of the ruble and the

dollar was not taken into account. Second, the radical

change of the structure of the military budget itself

was ignored. In economic practice, the so-called

currency purchasing power parity is used to conduct

international financial-economic comparisons. This is

done because the national currency exchange rate system

(both floating and also fixed) does not provide

satisfactory accuracy of comparisons of cost parameters

because the currency exchange rate system serves only

the sphere of foreign economic activity and not the

economy as a whole. Moreover, currency exchange rates

can fluctuate over the course of a year, a month, or a

day for various political and temporary reasons. Simply

speaking, purchasing power parity indicates the number

of country A's monetary units needed to purchase a

certain standard selection of goods and services which

one can purchase for one of country B's monetary units.

In dollars based upon the market exchange rate,

Ministry of Defense military expenditures are shown in

Figure 1 (in billions of dollars). It is obvious from

the figures cited that military expenditures in dollars

are ridiculously small if compared to the military

expenditures of the leading Western countries. However,

the military expenditures of the USSR, or later of

Russia, expressed in dollars always seemed to be a

curious thing. In 1989 the Soviet military budget was

approved in the amount of 20.2 billion rubles.

According to the official currency exchange rate ($0.70

to R1), this totaled less than $15 billion per year.

And at that level of military expenditures, the USSR

contrived to maintain military parity with the United

States, which spent $300 billion per year on defense.

 Billions of Dollar Exchange Rate

Years Dollars (Rubles per Dollar)

1993 7.4 932

1994 18.0 2,204

1995 12.8 4,554
12

1996 15.1 5,200

Figure 1. Ministry of Defense

Military Expenditures.

The conviction that the military ruble is quite a

bit "heavier" than the civilian ruble has become

ingrained in all the individuals involved in the

military budget based upon past experience. Actually,

at the end of 1980s, the USSR Academy of Sciences

conducted very complex calculations which have

convincingly shown that the defense ruble in the

production of military equipment was at a minimum 3-4

times weightier than the civilian ruble. So nobody

expressed any surprise that the Russian Armed Forces,

with a strength of more than two million, could be

maintained, for example, in 1993 on a budget that was

equivalent to $7.4 billion, according to the official

currency exchange rate.

But as market relations have advanced in the

Russian economy, the difference between the civilian

and military ruble has gradually disappeared. So, if

the ruble's commercial exchange rate in dollars totaled

10 percent of purchasing power parity at the beginning

of 1992, then it reached 65 percent of purchasing power

parity by the end of 1995 and has been slowly

approaching the official exchange rate since then.

According to data of the RF State Committee on

Statistics, the ruble exchange rate based upon

purchasing power parity totaled R271 in 1993, R988 in

1994, R2,759 in 1995, and approximately R4,300 per

dollar in 1996. If converted into dollars based upon

purchasing power parity, the Ministry of Defense

expenditures totaled $28.7 billion in 1993, $40.2

billion in 1994, $21.1 billion in 1995, and $18.2

billion in 1996. From this data, it follows that in

1993 the Armed Forces actually received not $7.4

billion, as it turns out during the conversion of the

military budget into dollars based upon the currency
13

exchange rate, but four times as much ($28.7 billion).

Consequently, in 1994 the Ministry of Defense increased

its budget by another $11.5 billion, to the quite

impressive sum of $40.2 billion.

The year 1995 became crucial when military

expenditures were immediately reduced by a factor of

two (from $40.2 billion to $21.2 billion). And that

wholesale reduction occurred under conditions of the

fierce war in Chechnya, for the conduct of which not a

single ruble was allocated according to the 1995 budget

(as, by the way, in the 1996 budget). According to

Ministry of Defense data, R5.71 trillion (that is,

approximately 10 percent of the entire military budget

for last year) was spent on the maintenance of the Army

Formation in Chechnya alone in 1995. Military budget

reductions of that scale occur in world practice only

after the end of large wars when the army is being

demobilized. However, even in that case, reductions

occur more or less gradually because the reintegration

of a large number of servicemen into peaceful life is

not cheap in democratic states. The situation was

totally different in Russia in 1995. It had not

completed any war; on the contrary, Russia had

precisely unleashed a war, although a local one. There

was also no reduction of the armed forces. The

reduction of the military budget by a factor of two

took place unexpectedly without any preliminary warning

whatsoever of the military leadership, thus the latter

did not have an opportunity somehow to adjust to it. A

further reduction of expenditures for the army, and a

quite substantial one (from $21.1 to $18.2 billion--

that is, by 13.5 percent) has been set forth in the

1996 budget.

Ignoring the structure of the military budget

itself was the authorities' second error. At the end of

the 1980s-beginning of the 1990s, if three-fourths of

the military budget went for the purchase of arms and

military R&D and only one-fourth for maintenance of

personnel, this ratio has become the exact opposite in

the last 4 years. Right now, one-fourth of the budget
14

goes for purchases and R&D. The remaining

appropriations are designated for the monetary

allowances of servicemen and salaries of employees,

payment of food and clothing, housekeeping and

utilities, infrastructure support of the troops,

medical service, payment of fuel, military transport

movements, and payment of pensions and construction

(mainly housing). As is seen from this list,

practically all military expenditures, except arms

purchases and R&D where market relations have still not

penetrated, are being carried out based upon consumer

prices. And this means that the compilers of the

military budget were simply obliged to set forth in it

the actual level of inflation during its development

and not that artificially lowered index-deflator, while

predicting military expenditures which lag behind the

actual rates of inflation by a factor of 3 to 4.

However, this is not even the main thing. Changing

the structure of the military budget has

disproportionately increased the impact on the Armed

Forces of the military expenditure reductions that were

being conducted. In 1992 Gaidar reduced military

purchases immediately by two-thirds which did not

arouse practically any resistance whatsoever from the

Armed Forces. The fact is that it struck not the Armed

Forces but the military-industrial complex which

usually forced its products on the Armed Forces,

without especially being interested in whether or not

the military needed them. Therefore the military has

always been less interested in the budget items for

weapons purchases and R&D (for which it in general did

not pay prior to 1991 and right now, it seems, does not

pay very much) than for the appropriations for the

maintenance of personnel and combat training.

Nevertheless, the presence in the budget of large

appropriations for the purchase and development of arms

substantially alleviated the Armed Forces' financial

situation, while permitting them to write off a portion

of the military budget reductions at their expense.

Now any reduction of the defense budget already
15

hits the very foundations of the military's existence--

food support, spares, medical service, and combat

training. In practice, all this means that more than

1.5 million Russian Armed Forces and 600,000 Ministry

of Defense civilian employees and all the military

pensioners must live on $15-18 billion per year. Common

sense rejects accepting the fact that one can maintain

a more than two million-man military armed force with

very complex modern weapons for this amount of money.

And, of course, in real life the Armed Forces have

weighty additions to their official budget. The Armed

Forces actually do not pay for utilities (electricity,

heat, water, etc.) and many of their orders, including

those for equipment, food, clothing and transportation.

This partly explains why the military has not mutinied

or simply dispersed at such a miserly level of official

defense expenditures.

But the situation cannot last forever. Defense

Minister Igor Rodionov says that the 1997 defense

budget covers only one-third of the military's

necessary expenses. The budget for 1997 envisions

spending R104 trillion, or $19 billion, on defense.

Added to these outlays are expenditures in the budget

on other military formations outside the Ministry of

Defense (border guard troops, interior troops,

different security forces, railroad troops, etc.) which

amount to more than R50 trillion. Given that all state

expenditures for this year come to about R500 trillion,

the share that will go toward defense and national

security accounts for one-third of the budget. It is

impossible to triple this share, as Rodionov demands,

without catastrophic consequences for Russia.

How did this situation arise in the first place? A

nearly total absence of competent military economists

and financiers whatsoever in both the government and

presidential structures and also in the State Duma and

Ministry of Defense has had an impact. Only a complete

loss of touch with reality can explain the fact that in

1995-96 the Russian leadership increased the strength

of the Armed Forces (by increasing the length of
16

conscription from 18 to 24 months), drove the army into

an expensive war in Chechnya, kept an enormous defense

industry by using feeble military orders, doubled

expenditures for military R&D, purchased from the

Ukraine strategic bombers that are mindlessly expensive

in operation and at the same time<D> dramatically (by

more than half) reduced military expenditures.

But of course the present financial predicament of

the military would not be so disastrous if it were not

for the terrible economic crisis that has been

unfolding in Russia in the 1990s. There are many

reasons for the depth and duration of this crisis. But

there is one which largely goes unnoticed both in

Russia and the West--Russia's failure to demilitarize

its economy. In hearings before the Senate Intelligence

Committee of the U.S. Congress in October 1993, I was

quoted as having stated that "there has been no

demilitarization of the Russian economy" and that "this

is the historic crime of the democratic leadership of

Russia." This certainly sounds like a gross

exaggeration in view of some well-known facts.

According to the Defense Industries Ministry

(Minoboronprom), in January 1997 the production of both

civilian and defense goods by the enterprises belonging

to the Ministry was only 17.8 percent of the output in

January 1991. The total number of enterprises belonging

to the Minoboronprom has fallen from 1,800 to just 500

in the past few years. By the end of February 1997 the

Defense Industries Ministry had not received a single

defense order for the current year. And yet, with all

that, I would stick to my "extravagant" statements

quoted in the U.S. Senate.

But first, "militarization of the Russian economy"

here deals more with macroeconomics, and much less with

tanks, guns, missiles, or evil doings of the militaryindustrial complex. To make this point clearer, there

is a great difference in the relations of the defense

industry to the economy as a whole in Russia and in the

West. In a Western country, possessed of a strong
17

defense industry--for example, the United States--the

defense-industrial base is part of a much larger and

often more efficient civilian economy. In Russia, which

inherited its defense industry from the former Soviet

Union, it was the very core and substance of the

national economy. The civilian part of it was merely an

adjunct to the defense sector and so inefficient that

in an open market economy, it simply could not survive.

The main reason for the low productivity of the

civilian sector is that for more than half a century

all the best technologies, material, and human

resources of the country were being channeled into

defense and related industries, while civilian

industries and the economic infrastructure were doomed

to partial or complete inefficiency. The backwardness

of the civilian industries is proportionate to the

funds diverted from them into the defense sector. This

kind of economy can exchange its products only on a

compulsory or noncommercial basis: through direct

distribution of resources at artificially fixed prices.

In other words, an economy like this can function only

if it defies the laws governing market systems. If such

an economy were to switch abruptly to prices

corresponding to world prices, the system of ties

between them would eventually and inevitably collapse.

And this is exactly what has happened in Russia over

the last 5 years.

The distortion of an economy which does not

respond to such measures as cutting defense

expenditures or defense purchases and does not allow

overflow of financial resources from the defense into

the civilian sector is structural militarization as

opposed to the usual militarization which can be

measured by the shares of defense spending and defense

production in national budgets, GNP, etc. All defense

procurement in a structurally militarized economy can

be stopped, and still this drastic measure will not

result in a corresponding increase in efficiency of the

civilian economy or other noticeable changes in the

economy for the better.
18

Such an economy is completely unknown in the West,

where defense cuts sooner or later lead to a flow of

resources from the defense to the civilian sector.

People move to new jobs, new specialties, or new

locations. Factory buildings are sold, machinery is

auctioned to new owners in a very active market, and

land is sold to new owners. Defense conversion in the

West is thus a diffuse activity. Demand falls in one

sector and rises somewhere else. Nothing like this has

happened in Russia so far, despite huge cuts in defense

purchases--nor is it likely to happen in the

foreseeable future, even if defense cuts go on. The

failure to comprehend these fundamental differences

between the economic systems of Russia and the rest of

the industrial world explains the excessive optimism of

the Western public and politicians about the prospects

of market reform and demilitarization in Russia.

Unfortunately, the difficulties of dismantling a

structurally militarized economy have been ignored by

the Russian reformers themselves. As a result, they

have committed several grave mistakes, have wasted

precious time, and, sad to say, lost some irretrievable

opportunities to thoroughly dismantle Soviet-Russian

militarism. Their biggest mistake was a firm belief

that money can play a decisive role in changing the

ways of the Russian economy, and that it can be managed

with the help of a budgetary and credit policy. It is

certainly tempting to use financial indicators in

summing up the results of economic development and

formulating its goals, instead of getting bogged down

in the intricacies and problems of technological and

structural imbalances between the civilian and military

sectors of the economy. Moreover, this practice of

using financial indicators is accepted all over the

world and is intellectually and administratively not

very demanding, with ready-made and tested recipes

galore.

I realize that all my conclusions are not

inspiring. I have deliberately refrained from
19

discussing more desirable or ideal ways out of Russia's

current predicament, knowing that the state of mind and

the prevailing forces in my country make such a

discussion rather unrealistic. Russia to a growing

extent displays many of the maladies of a vicious

circle of failed reforms. It is difficult to tell if

the Russian government really believes in any policy

besides its own survival. A series of flip-flops,

retreats, and promises over the last years suggest that

practically nothing the government says or does

concerning economic policy can be taken seriously.

Budget revenue is coming in at a rate of just 60

percent of the forecast; investors are not investing;

enterprises are bartering to avoid taxes; and, lobbies

are begging an already bankrupt government for money.

With the news coming from Russia, full of lurid tales

of backstabbing, intrigue, and corruption, it may seem

as if Russia is back to the age-old Byzantine

traditions of the Kremlin politics. And yet the last 5

years of reform were not without their positive sides

for the economy. Despite the fact that Russia continues

to be misgoverned, a genuine private sphere existing

outside the state has appeared for the first time in 80

years. The growth of civil society gives some hope that

Russians will one day expect their government to serve

them, not the other way around. Besides, virtually

everything that unfolded in Russia in the last years

did so in the full daylight of media scrutiny. And, by

and large, after October 1993 when President Yeltsin

dissolved the parliament, no official acted openly

unconstitutionally. It is not a real democracy, to be

sure, but certainly a vast improvement from just 5

years ago, even in the middle of a no-holds-barred

power struggle. Conventional wisdom notwithstanding,

the more Russia changes, the more it seems not to be

the same.
U.S. ARMY WAR COLLEGE

Major General Richard A. Chilcoat

Commandant

*****

STRATEGIC STUDIES INSTITUTE

Director

Colonel Richard H. Witherspoon

Director of Research

Dr. Earl H. Tilford, Jr.

Author

Vitaly V. Shlykov

Director of Publications and Production

Ms. Marianne P. Cowling

Publications Assistant

Ms. Rita A. Rummel

*****

Composition

Mrs. Mary Jane Semple

Cover Artist

Mr. James E. Kistler