Cut Out for an Economic Miracle

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In his state of the nation address to the Federal Assembly, President Vladimir Putin set the target of doubling GDP over the next 10 years. In order to achieve this objective, average GDP growth must be no less than 7.2 percent per year.

This is an entirely realistic goal as is corroborated, first, by the experience of those 68 countries that in the past half-century have managed to double their GDP over a 10-year period and, second, by Russia's actual GDP growth between 1999 and 2003, which averaged 6.2 percent per annum.

Growth in the first half of this year, as compared to the same period of last year, also looks rather encouraging. The numbers are as follows: GDP growth of 7.2 percent; significant growth in industrial output; double-digit growth in investments, and the export and import of goods; and growth of household incomes by more than 14 percent in real terms. Russia is currently experiencing an economic boom.

However, even such an invigoration of the economy should not give grounds for complacency, as Russia's real place in the world is far from what it is sometimes made out to be.

Comparing the basic indicators for Russia -- territory, population, GDP -- with those of the United States and China, one can see that it is only in the size of territory that Russia outstrips those countries. In terms of population, Russia is half the size of the United States and one-ninth the size of China; in terms of GDP (adjusting for purchasing power parity) Russia is approximately one-ninth the size of the United States and 17 percent of China.

There are two main groups of factors affecting economic growth. One is "luck," or the factor of favorable external economic conditions; the other concerns government policy.

The "luck factor" in essence revolves around the national terms of trade, i.e. the relative price of goods that the country exports and imports. Money received as a result of movements in the price of these goods constitutes a "grant" from the world economy. For example, when a Russian exporter sells a ton of oil and gets $240 for it instead of the $80 he was receiving, ceteris paribus, he can purchase three times more goods by physical volume. If, in addition, the price of imported goods falls, then the "grant" from the world economy increases and the exporter can purchase even more goods and services.

Over the past four years, we have been receiving a sum equal to 9 percent to 13 percent of GDP each year from the world economy. Part of that sum -- a pure grant of 6 percent to 9 percent of GDP -- automatically increased the size of GDP. Thus, economic growth in Russia in recent years has been closely tied to external factors.

Growth is possible only when the national economy is competitive. The main impediment to competitiveness is the high costs of doing business in Russia, which are primarily a result of the size of the nonmarket sector (the government sector, monopoly sector, government regulation, as well as the level of the real exchange rate).

I will focus on one element -- the government sector's share in the Russian economy.

Over the past 40 years, OECD member countries' experience has demonstrated that there is a negative correlation between the size of the government sector (measured in terms of government expenditure as a share of GDP) and economic growth rates. In other words, the larger the government sector, as a rule, the slower economic growth.

This holds not only for highly developed countries but also for transition economies. When the share of government spending in transition countries exceeds 40 percent of GDP, as a rule, economic recession ensues.

China's experience over the past quarter of a century provides a particularly graphic example of this. China achieved its highest growth rates in the mid-1990s when government expenditure as a share of GDP was minimal -- approximately 14 percent (in 1979, it was 36 percent). In recent years, however, with the government share in GDP increasing, growth has slowed somewhat, although it remains extremely impressive.

In what areas did China reduce spending as a share of GDP? Reductions were made almost across the board, but in particular on subsidies to the economy, on social security and consumer subsidies; even spending on education and culture was reduced. And defense expenditures were substantially reduced, from 5.5 percent in 1979 to 1.1 percent in 1995. In fact, the essence of China's economic success has been its acceleration of economic growth by reducing the share of government expenditures in GDP. However, in the past six or seven years there has been a rapid increase in government spending as a share of GDP up to 22 percent, though it is still far lower than it was in 1979.

In 1992-94, when Russian government expenditure was at its peak, at about 50 percent of GDP, there was no growth; in fact, the average annual growth rate was negative, at minus 12 percent per year. In 1995-98, the government's share of GDP was reduced to 41 percent, and economic recession became milder, at minus 3 percent per annum.

The best results of the past 12 years were achieved in 1999-2001, when the share of government expenditures in GDP was reduced to 33 percent and economic growth was more than 7 percent per year. Finally, in 2002 with government spending rising to 37 percent of GDP, economic growth fell to 4.3 percent.

What would be the optimal level for government expenditures? In order to ensure sustained growth of 8 percent per annum, we need to reduce government spending as a share of GDP to 20 percent to 22 percent.

There are three possible scenarios for economic policy in the medium-term:

1) Increasing government spending to 40 percent of GDP (this seems to be the option favored by left-wing economist Sergei Glazyev).

2) Reducing the share of government expenditure in GDP to 30 percent, as was reluctantly tolerated by the Center for Strategic Research in the spring of 2000.

3) Reducing the share of government spending in GDP to 20 percent, as proposed by the Institute of Economic Analysis and by me.

One can make forecasts regarding average annual GDP growth based on these scenarios, irrespective of the terms of trade index. Under the first scenario, the trend growth rate is going to be minus 0.4 percent per year; under the second, 3.8 percent per year; and under the third scenario, up to 8 percent per year.

Looking ahead to 2015, under the first scenario per capita GDP could grow by 5 percent, under the second scenario by 72 percent, and under the third scenario it could increase by a factor of 2.8.

The most striking fact in this comparison is that the most significant increase in per capita government expenditure would also be achieved under the last scenario, not under the first.

In other words, one can say that not only the optimal policy but also the most "statist" policy (i.e. that leads to an increase of real government expenditure) is that of gradually decreasing the share of government expenditure in GDP. This will ensure the highest per capita GDP and the highest level of government spending per capita in the medium-term.

Reducing the share of government spending to 20 percent of GDP could be a condition for ensuring high economic growth rates in the medium-term, the first step toward doubling the country's GDP in the coming years, and a necessary though insufficient basis for bringing about an economic miracle in Russia.

Andrei Illarionov is economic adviser to President Vladimir Putin. He contributed this comment to The Moscow Times.