Fri, Oct 16, 2015 page9

• Trade sanctions might make Russia the next economic miracle

  • By Richard Werner and Vladimir Yakunin
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  The economic sanctions imposed on Russia by the West in March last year have undoubtedly been painful, but they have so far failed to achieve the goal of weakening Russian President Vladimir Putin’s position. In fact, they might have the opposite effect, leaving Russia — and its president — even stronger than before.

  EU nations are estimated to have lost about US$100 billion in trade with Russia, hitting the likes of Bavarian dairy farmers and eastern German industrial exporters. Russian GDP, which grew modestly last year, contracted by 4.6 percent in annual terms in the second quarter of this year. The ruble lost more than half of its US dollar value in the second half of last year, fueling inflation, which increased by 15.6 percent year-on-year in July.

  However, inflation now seems to have peaked and the effects of the drop in oil and gas prices were mitigated by the US dollar’s appreciation, so that the value of Russia’s foreign reserves actually increased, reaching US$362 billion in June (13 percent of which is in gold). And despite belt-tightening measures in Russia, Putin is more popular than ever.

  The rationale behind economic sanctions is straightforward: free-trade and free markets deliver growth — and thus political support for the government — whereas restrictions choke off growth — and thus erode support for the government. This emphasis on free trade and free markets was a central tenet of 19th-century British classical economics. It remains a core message of today’s dominant neoclassical school — embodied in the so-called “Washington Consensus,” adopted across the world under the IMF’s advice — which claims that the key to economic development is to open up, deregulate, liberalize and privatize.

  However, the theory is fundamentally flawed. No economic power has ever developed solely on the basis of laissez-faire policies. The economic rise of the UK, for example, was heavily dependent on strategic protection, industrial policy, tariffs and non-tariff trade barriers.

  The UK’s industrial prowess originated with the textile industry. The nation’s leaders realized that the export of raw materials, mainly wool, would be inadequate to spur economic development. For that, England would have to move up the value-added ladder, by importing raw materials and exporting finished goods.

  So England’s leaders devised an industrial policy, which entailed bringing in Flemish textile weavers to provide know-how to UK firms. Moreover, they erected trade barriers: By banning the export of raw wool and the import of finished wool products, Indian textiles, which were often superior and cheaper, could not compete with domestic output. They adopted navigation laws that restricted foreign ships’ access to UK ports and even enacted a demand-boosting law requiring the dead to be buried in woolens. Ultimately, the mechanization of the textile industry ushered in the Industrial Revolution, and mass production and exports underpinned the development of the world’s largest maritime fleet.

  In the mid-19th century, the German economist Friedrich List highlighted the role that such policies played in the UK’s development. In line with his advice, the US, Germany and Japan employed judicious trade protection and industrial policies, while working actively to support nascent sectors — a strategy that enabled them to develop rapidly and even overtake the UK.

  Restrictions also proved effective to spur economic development: In 1812, when the UK declared war and imposed a trade embargo on the US, import substitution caused US manufacturing to flourish. When the embargo was lifted and trade tariffs were reduced, US manufacturing floundered — until 1828, when new UK tariffs boosted US manufacturing again. Likewise, during World War I, a UK trade embargo spurred the development of German high-tech industries due to the demand for substitutes.

  Of course, embargoes can have a devastating effect when a nation lacks the resources needed for import substitution. That is why economic sanctions were so damaging for Iran and earlier, for Iraq’s population.

  However, for a nation like Russia, with its abundant natural resources, technological expertise and skilled workforce, sanctions can have the opposite effect. The Soviet Union struggled to capitalize on these factors, owing to communism’s weak incentive structure. Today, by contrast, Russia has a capitalist system that offers considerable benefits to those who adapt best to the restrictions.

  In short, Russia has all it needs to thrive, despite — or because of — the sanctions, but turning opportunity into reality requires Russia to pursue an economic transformation.

  Neoclassical trade theory is built upon the concept of comparative advantage: Nations should capitalize on their relative strengths, from technological prowess to resource endowments, but, as British leaders knew, and as the experience of many African and Latin American nations has shown, simply exporting raw materials is inadequate to propel development.

  Historically, the most effective development policy has centered on government intervention to establish higher-value-added domestic industries. In previous decades, Taiwan, Japan, South Korea and China have all taken this path.

  For Russia, moving up the value-added ladder should not come as a challenge; it has all it needs to manufacture the finished products that it previously imported.

  In fact, import substitution has already increased productivity in several key sectors: engineering, petrochemicals, light industry, pharmaceuticals and agriculture. Annual exports of high-value-added goods rose by 6 percent in the first quarter of this year.

  Furthermore, Russia’s leadership has accelerated cooperation with the other BRICS economies (Brazil, India, China and South Africa) and Putin recently announced ambitious plans to boost domestic demand.

  The West’s sanctions against Russia might not only fail to change the Ukraine situation; they might well spur the nation’s long-awaited structural transformation.

  If Russia successfully replicates the credit-guidance regime used by East Asia’s economies, while increasing managerial efficiency, yet another economic miracle is possible.

  Richard Werner is a professor of international banking at the University of Southampton. Vladimir Yakunin is chair in state policy at Lomonosov Moscow State University, founding president of the World Public Forum and a former chairman of Russian Railways.

  Copyright: Project Syndicate

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