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. Last Updated: 07/27/2016

Breaking Inflation's Grip

Inflation has become a sign of the times in Russia, and in this regard there have been few indications of optimism lately from politicians charged with the country's economic future. Most experts believe that the cause of inflation is the country's chronic budget deficit, which is running at about 8 percent of the gross domestic product. However, this explanation is too facile, since it treats inflation as just a matter of the technical relationship between the state's revenues and expenditures and prescribes a simplistic way of dealing with the problem.

Common sense tells us that it is not the budget deficit itself, but the causes of the deficit, that are inflationary. In other words, inflation is caused by the nature of the expenditures that are financed by Central Bank credits. In 1994, such credits rose from $8 billion to $16 billion, after being adjusted for devaluation of the ruble. To understand inflation fully, one must appreciate how the government uses credits, which amount to direct issues of currency.

If, for example, deficit spending is used to finance new production technologies or new products, then the result is increased production and growth of domestic markets. The increased demand for money that would result could be compensated by imports until domestic producers, under the influence of foreign competition and with the help of state investment, are able to make competitive products. In such a case increased expenditures actually help gradually overcome inflation, while imports are used to prevent shortages.

It is a completely different story, though, when state credits are used to support ineffective production. In this case, the inflationary effects of deficit spending are out of proportion with the spending itself, as is its destructive influence on the economy. This is the scenario we have seen in Russia to date.

Privatization has not yet led to the formation of an effective economic structure that is capable of meeting the demands of the market. Outmoded forms of agricultural organization, worn-out production equipment and a lack of modern mass-production technology all mean that domestic producers simply are not capable of producing goods and services that meet the rising criteria of the average consumer. Because there is no effective state investment program and no general policy regarding the structure of the economy, we are witnessing only a slow, torturous development of domestic business and the middle class -- that is, of the economic base of a modern industrial society.

The danger of social unrest spurred by the collapse of production restrains the government from taking radical measures to reduce expenditures. However, the main culprit in the massive interenterprise debt problem is the government itself, which has been withholding payments for deliveries of oil, coal and other raw materials. These shortfalls are passed along in the form of unpaid wages, which has profoundly destabilizing social consequences -- the most visible of which are the strikes that have been springing up around the country.

On the other side of the ledger, the government has been trying to balance its incompetent expenditures with incompetent revenues -- high taxes, customs duties and other excises. Caught in a vice between non-payment and high taxes, business capital and individual savings are being rapidly drained. As a result, there are no sources of private investment.

As domestic goods are squeezed out by imports, excises and duties exercise an ever-increasing influence on domestic prices, pushing them upward. At the same time, the government continues to pour the revenues it receives from such duties into ineffective production, which increases the demand for money and inflates prices.

State bureaucrats simply do not understand that it is not low prices for imports that push domestic products out of the market but high local production costs resulting from outmoded technology and poor organization. Russia's financially strapped consumers are making rational choices.

Strange as it may seem, the West is also playing a role in keeping up inflation in Russia. The credits that Russia receives from international financial bodies do not stabilize the economy, but rather intensify the economic crisis. In reality, such credits support the old production system and exhausted plants and artificially increase wages that should really only rise as production picks up.

Now Russia is trying to join the General Agreement on Tariffs and Trade, even requesting special treatment with regard to customs duties on imports. What will be the result? Imports will go up and the circle of payments will be closed. Russia's foreign debts will be paid in part by foreign importers. Inflation will continue for years, and, against their will, foreign creditors will be drawn into this chronically inflationary process.

Russia does not need foreign credits. If the government lacks the courage to turn them down, then the international community must summon the courage not to offer them.

Russia needs private investment. In order to get it, Russia must create a system of incentives, including state guarantees for both foreign and Russian investors. The government must break its dependence on import duties. If importers can make more profits selling in Russia, they will come to understand that it would be even more profitable to produce here. Some money that is now leaving the country would return as investment in production.

The state must also reduce taxes and increase support for local businesses. It may even make sense to convert the country's foreign debt into share packages of privatized firms -- that is, into real property within Russia. Finally, conditions must created to encourage individual savings. Such well-thought-out measures -- not foreign credits or increased customs duties -- are the only way to break the cycle of inflation in Russia.

Vladimir Milovidov is a professor of economics at the Institute of World Economy and International Relations. He contributed this comment to The Moscow Times.