The bank that foreclosed on Russia: Heads should roll after the Western aid debacle that killed off reform, says Jeffrey Sachs

THE COMMUNIST old guard reasserted political dominance in Russia last week. The resignations of two key reformers, Yegor Gaidar and Boris Fyodorov, from Boris Yeltsin's cabinet are not just a failure for the Clinton administration, which has blithely accepted President Yeltsin's commitment to reform, but a serious setback for Russia's move towards democracy. Western governments are now likely to spend much more on their military budgets than they would have on direct aid to Russia.

Most Western observers never understood the bald facts of political life in Russia. While pundits debated the relative merits of shock therapy versus gradualism, the real issue was far simpler: would reformers have the political strength and Western financial backing to pursue a sensible and consistent financial policy, or would they be done in by a bitter and corrupt Communist opposition?

For two years, reformers in Moscow struggled for power while Western governments promised them large-scale aid. The financial crisis bequeathed by the Communist regime was too deep. The reformers could not win without outside help, but help never arrived, and the reformers paid the price, losing badly in the December elections.

The United States and its allies had given the task of bailing out Russia to the International Monetary Fund and the World Bank, principally because such institutions can make loans that do not require congressional and parliamentary authorisation.

While the IMF and World Bank proudly took the limelight, they made sure, like private bankers, that no significant amount of their money would be risked in unstable Russia. Of the roughly dollars 18bn ( pounds 12bn) that they were to lend to Russia in 1993, only dollars 2bn was handed over. This may have been prudent banking practice, but it was disastrous foreign-assistance policy - and worse foreign policy.

What is even more troubling is that these institutions blundered in their assessment of the situation. It was not just excessive caution that stopped the flow of support; it was also their lack of understanding about what to do.

The urgent tasks of financial reconstruction were admittedly complex, but the broad outlines should have been clear. Mikhail Gorbachev and the Communist regime had left Russia in a financial shambles, with a budget deficit of more than 20 per cent of GDP paid for by printing money; a rampant and corrupt flow of subsidised loans from the central bank to the state enterprises; an unpayable foreign debt; and depleted hard currency reserves.

The main goals of financial policy should have been to reduce the budget deficit; to float new government debt on the domestic market in order to cover the budget deficit without printing new money; to staunch the flow of cheap government loans to weak industries; and to establish a separate Russian currency so that the country could pursue a monetary policy independent of its neighbours. At the same time, international grants and loans should have been provided to help the government to pay its bills.

All these tasks were urgent and mutually dependent on each other.

Critics may derisively call the package 'shock therapy', but these measures are the essential remedies for a financial collapse, and have a pedigree stretching back to Alexander Hamilton's rescue of American finances in 1790, Hjalmar Schacht's solution for Weimar Germany's hyperinflation in 1923 and Ludwig Erhard's creation of a democratic market economy in Germany after the Second World War. In all those cases, outside help was crucial.

The IMF failed miserably in advising the Group of Seven countries and the Yeltsin administration on Russia's financial reconstruction. It discouraged Russia from rapidly introducing a separate national currency. For two years it downplayed the need and ability to issue domestic treasury bonds, focusing nearly all of its efforts on pressuring the Russians to make politically impossible cuts in their budget deficit.

It advised Russia against the stabilisation of the rouble exchange rate, and held back a rouble stabilisation fund designed to support such a policy. Most remarkably, it never acknowledged the urgency of mobilising international assistance to help Russia to finance its deficit.

The IMF's relentless advice was to cut the deficit, not to find acceptable and non-inflationary ways to finance part of it. The World Bank also failed in its most important task: to help to finance a viable social support system.

Why was the IMF so inept? For 50 years, it has been nearly as secretive and monopolistic as the Central Committee of the Communist Party. All the IMF's Russain loan documents are secret. The only information it publishes is general economic data, not specific policy advice. It is cut off from independent professional scrutiny and competition. It alone determines whether Western aid will flow. Like any long-standing monopoly, it has grown arrogant, self-protective and sloppy.

And yet whenever anything goes wrong with an IMF programme, the United States Treasury and G7 governments draw the wagons around it.

Western governments have to understand that it is one thing to defend the sound principles espoused by the IMF - budget discipline, responsible monetary policy, open markets - and another to cover up the shortcomings of its technical work and reluctance to make loans in urgent circumstances.

The reformers may or may not get another chance in Russia. Now that they are no longer heading the key ministries, there is little the West can do. It will have to watch how the policies of the new government develop, but it makes little sense for the Clinton administration to commit large-scale economic assistance unless reformers regain power. In any case, Western credibility over aid is at a low ebb.

If reforms somehow continue, the worst response by the West would be to send an unreformed IMF back into the fray.

The IMF's managing director, Michel Camdessus, should accept responsibility for this debacle and step down. The organisation requires new management and a new direction, based on the best practices in financial stabilisation, risk-taking in lending money and openness to professional scrutiny.

The best the West can do now is to prepare for another chance to support reforms, before Russia poses a renewed threat to itself and the rest of the world.

The New York Times.

The author, who is professor of international trade at Harvard University, resigned last week as economic adviser to President Boris Yeltsin.

(Photograph omitted)