It was always known that Russia's economic transformation would be more arduous than that of countries outside the former USSR. Historical, mental, geographical and economic "distance" from a market economy was longer. Contrary to other countries, socialism was endogenous: it had been established, developed and defended by the Russians themselves. What is more, in many respects the Soviet Union was the proudest achievement of Russia. Its geographical expansion, military might and global position were stronger than ever before. Even more importantly, contrary to the Central European countries, there was no widely shared understanding of the systemic goal to be adopted.

For the Central Europeans, the overarching goal of "returning to Europe" meant joining the European Union, NATO, the OECD and the rest of the Euro-Atlantic alphabet soup as soon as possible. Joining these clubs with their sometimes hugely detailed membership requirements--the EU Acquis run to some hundred thousand pages--sets a strict conditionality upon the institution-building and policies of the applicant countries. This conditionality may not be the best imaginable, but it has a degree of consistency and proven applicability in other countries. Therefore, though governments and other decisionmakers have changed, the Central European countries have had a high degree of policy consistency, which may have made the most important single contribution to their unexpectedly positive economic and social progress.

Such conditionality was not available to Russia and the rest of the USSR. The European nations have--perhaps unwisely, at least after the status of Turkey as a potential member has been reasserted--denied Russia the prospect of eventual EU membership, usually giving the size of Russia as the reason. By doing this, the incentives of the only unifying goal that Russia might have had were abolished. Most Russians, on the other hand, have been keen to emphasize that Russia has never been and never will be a "normal European country." But like earlier in history, they have been unable to provide the nation with any other consistent and well-defined goal. And like the Cheshire Cat taught Alice in Wonderland, if one does not know where to go, any road will take one there. The conditionality of the international financial institutions has been almost the only one available. Even under the best of circumstances, it will be narrow and technical. In Russia's case, the circumstances were not the best ones, as the IFI's have been under much unfortunate political pressure to use money.

This is probably the single most important explanation for the divergence of Russia's economic performance from that of the Central European countries. The lack of a well-defined and widely accepted goal has tended to shorten decisionmaking horizons and has facilitated the frequent capture of policies by established interests. On one hand, the state has been weak in the sense of lacking a strategy and being unable to act in a consistent way. On the other, it has remained the major route toward power and privilege, disposing of even the seemingly most entrenched persons and groups when their services are no longer needed. Still, Russia has not chosen "any road." The return to the previous regime was never an alternative seriously supported by a major political force. Russia was always in a transition to something new, but it remained unclear what this "something new" would be. Also, the Russian elites have been able to learn from their mistakes. It was possible to argue in the early 1990is that large budget deficits and high inflation were a means to provide jobs and welfare. Such arguments have lost all credibility. This was shown by the chasm between the rhetoric and actual policies of the Primakov-Maslyukov government. The set of possible policies has shrunk over time. Most talk of some specific Eurasian system has died away. There is a wide consensus on basic macroeconomic policies, but a clear-cut model of institutions and legislation is still missing.

Clearly, this is not a situation where piecemeal social engineering should be attempted. But quite as clearly, arguments about the weakness of the Russian state have been used to justify the lack of consistency and comprehensiveness. This still remains the case. The attempt to combine economic market orientation and political authoritarianism, together with the actual weakness of the presidency hidden behind rhetoric and symbolism, produce hesitancy, a lack of decisions, and a tendency to balance conflicting interests. Equaling the restoration of Russia's might with an unchallenged prestige of the president adds the dimension of attempted "verticalization" of the society, with little room left for an independent society and media. In the economic sphere, the outcome is an almost complete lack of meaningful structural reform.

Russia has become a market economy, but a market economy that is unique in many respects.
- The Russian large-scale privatization was based on two explicit considerations. First, it was (probably wrongly, given that a return to the past was not an alternative) asserted that there was a need to secure irreversibility by creating a wide class of property owners. Second, there was need for political compromise with the Duma. These considerations combined to produce Option Two of the privatization program, in fact making wide insider ownership inevitable. As some two-thirds of Russian industry was privatized, in about two-thirds of the cases about two-thirds of the stock ended up being owned by insiders--that is, managers and employees. The dilution of insider ownership has since been much less than expected by the optimists, and in many cases the presumed outsiders are acting for the managers.
- Most Russian enterprises are manager-dominated, with employees still an important though usually silent group of owners. Managers often claim to speak for the "work collective" and take a very cautious view of outside investors or even bank credit, as those are deemed to limit their power. Investment, structural change and growth suffer. Economic theory suggests that an insider-dominated economy fails to reach the dynamism connected with more usual distributions of property rights.
- Insider privatization partly explains the low degree of monetization of the economy. Meager financial intermediation and the relative lack of financial institutions--including proper banks--are also due to a history of high and variable inflation and the policy mistakes leading to the financial crisis of 1998. Though the role of money as a means of exchange strengthened much in 1999-2000, about a fifth of industrial production is still based on barter, and there is little evidence of financial deepening. Modern growth theory argues that financial depth is a major contributor to growth and welfare. Financial sector reform seems to have little priority in Russian policymaking. Real investment grew strongly in 2000 from a low level, but as most of it is financed from retained earnings, the investment pattern tends to strengthen the inherited structure of production. New enterprises, in particular, remain constrained by the availability of finance.
- The relative lack of new private activities separates Russia (and other states of the former Soviet Union) from the Central European countries. The number of legally registered enterprises has not grown for several years; nor is there evidence of an ever-growing share of the second economy. New activities are not only hindered by the lack of finance, but also by the neglect or hostility of local authorities. On the average, Russian regions are small entities, often dominated by a single plant or a few large plants, usually in alliance with the authorities. Quite often, such powers see new entrepreneurs either as a milking cow or as an alien element to be suppressed. If Putin's campaign to cut the regional barons down to size indeed brings about a more unified economic space with a more level playing field for entrepreneurs, it should be welcomed on economic grounds. So far, Russian regionalization has tended more to worsen economic behavior than to make room for local initiative.
- The border between legal and not legal has remained fuzzy. This is another defining feature of Russia's economic environment. Putin's regime promises political stability and greater clarity of rules across the country. There are also the well-known cases of political misuse of the legal system. The poor performance of Russia's capital markets shows that the investors do not trust Putin to deliver a working combination of political authoritarianism and economic liberalism.
- GDP growth since 1999 has been fueled by a stiff undervaluation of the ruble, responsible macroeconomic policies, the adaptation of many enterprises, and by high commodity prices that have not been fully reflected in domestic markets, thus generating a huge implicit subsidy to domestic users. Following a tremendous export surplus, the economy has been partly monetized, fiscal revenue has ballooned and the greatly improved enterprise profitability has translated into investment, settling of arrears and higher wages and consumption. Net exports are bound to diminish, but still the economy should be able to grow for a year or two more. After that, growth depends much more on necessary structural reform. This need is generally recognized, but in 2000 only tax reform had some success.
- In spite of the currency undervaluation, Russia has no new export commodities. Most growth has been in import substitution. Only traditional Soviet goods are exported. This suggests the probability of a traditional dual economy in Russia. Most export revenue would be earned by selling resources and other basic commodities abroad, primarily to the European markets. Most employment would be generated by home market industries producing low quality commodities for poor consumers. Such an economy would be sustained either by currency undervaluation or other restrictions of trade. The lack of market-based policy instruments makes the latter alternative more probable.

These peculiarities of the Russian market economy may well be systemic and not just the unfortunate consequences of the macroeconomic circumstances of 1985-1998. They do seem to characterize an economic system of some consistency and, therefore, staying power, but one that is badly suited for efficiency, equity, growth and welfare. If so, Russia would tend to remain what it is today: an economy the size of a smallish European nation; a factor in the global economy much weaker than, say, Sweden; and a country of large welfare gaps and little dynamism. It would sustain itself by exporting basic commodities and by subsisting on goods and jobs created by protected home market industries. The outward capital flow might well continue to dwarf the inward flow, as is the case now. There would be links between domestic and world financial systems, also some necessary inward productive investment, but as a whole Russia's economic marginalization would continue. Only the most optimistic spokesperson of globalization would argue that this is an impossible outcome. A nation can still step aside from the great change underway.

This is an outcome that the Russian authorities fear. Economic marginalization cannot support great power ambitions. Vladimir Putin has been very explicit on this, but the track record of 2000 tells of an inability to make and implement the needed reforms. The Russian economy may in a sense be less virtual than a couple of years ago, but Russian economic policies remain very much so. The Putin regime had in 2000 a great chance to create the foundations of Russia's future growth. After 2001, that chance may not come again.

The final downside of Russia's economic transition is the inability to address the underlying trends that have been there for so long. The list of these ills is all too long and well-known. Current forecasts for medium-term growth are coming down to three percent annually. If at best the economy will grow quite modestly, the struggle over the meager additions to available resources will to a great extent determine Russian politics in the coming years and decades. As the increase available will in any case be insufficient to cover all urgent needs and there is little reason to expect highly rational decisionmaking and implementation, the probability of ruptures, disconnects and fissures increases alarmingly. The international community has already learned that the possibilities of making a crucial difference in Russia's development do not exist. If the arguments outlined above have any value, then the question will increasingly become one of damage control and limitation.

US National Intelligence Council