Jeremy Lennon. Jeremy is the International Rule of Law, Governance, and Security program intern for the Fall 2020 semester. Jeremy recently graduated with a degree in comparative politics and government and is interested in security, governance, and development in the former Soviet Union.
This is the second blog in a series on Illicit Russian Money. Read the introductory post here.
Russia’s extreme capital outflows are a result of poor rule of law, and the resulting weak property rights.
Since 1990, $800 billion have permanently flowed out of Russia. This has adversely affected Russian domestic investment and contributed to Russia’s stagnating economy. In the 1990s, $43.4 billion in IMF loans were more than offset by at least $150 billion in capital flight. Although the Kremlin recognizes the problem and still tries to stem the flow through more regulations and the occasional legal case, this is highly ineffective due to poor governance and because Russia’s leaders themselves are responsible for significant sums of money flowing overseas.
Russia has been perennially corrupt since its independence as a result of continued practices from Soviet times. In the Soviet Union, off-the-book dealmaking and informal connections were the only way to make the command economy function, but as the Union disintegrated, these connections were used by bureaucrats and Kremlin insiders, among others, to privatize massive amounts of wealth in corrupt deals. For example, all of Russia’s vast mineral wealth was privatized for around $12 billion, less than the value of the Anheuser-Busch beer company. In 2005, it was estimated that the total amount of bribes paid in Russia was equivalent in size to the national budget. In 2008, it was estimated that 30-50% of the defense budget was either “misused” or just outright embezzled. The corruption extended from the lowliest bureaucrat up to the inner circles of both Presidents Yeltsin and Putin.
In this wild-west economic atmosphere, there was neither the capability nor the willpower to enforce the rule of law. If unbiased investigative and legal institutions were developed, assuming that this could have been done, they would have necessarily gone after Russia’s leaders, businessmen, and state officials.
The lack of rule of law had other implications as well. Without adherence to a transparent and uniformly-applied legal system, which is needed to make formal political institutions function, the operation of the state bureaucracy becomes opaque not just to the citizenry, but to the state’s leaders as well. Without functional investigative institutions, bureaucrats are able to conceal rent-seeking actions from their superiors. They form informal networks throughout institutions to shield themselves from accountability and consequences. As a result of this, economic advisors issue policies and edicts that fall on deaf ears. Without direct intervention from the president, it is hard to kick the poorly functioning bureaucracy into motion.
Subsequently, Russia’s currency exchange laws and business regulations have become byzantine as more regulations are created, thus creating incentives or justifications for even honest businesspeople to ignore them. Russian regulatory institutions remain so dysfunctional that illegal practices such as double accounting and tax evasion have become necessary (or at least justifiable) to run even an otherwise legitimate business. As a result, nearly everyone operates in a gray area where such actions are socially accepted, but technically illegal. This allows the wealthy and well-connected to manipulate the legal process against competitors.
A wealthy businessperson in Russia is able to bribe or pressure local tax agents to investigate a rival business. If an investigation ensues, the business will almost assuredly be found to have used illegal accounting practices. At this point, the business is seized, and put up by the courts for “auction,” which is rigged by the businessman who kicked off the original proceedings. The rival business is eventually bought at fire-sale prices. Thus, medium-sized businesses and successful entrepreneurs are motivated to move as much money as they can out of Russia so that they have a financial safety net if their business is seized.
The irony of this is that even the property rights of Russia’s leaders are not secure. Their current security is tied up with their political power. If Putin and his supporters were ousted in a “color revolution,” said to be Putin’s greatest fear, they, like other ousted leaders, would lose all of their property inside Russia. As a result, Kremlin leaders discreetly move their money overseas into jurisdictions with strong rule of law, and strict secrecy laws. If they are pushed from power and must go into exile, these officials would still have massive assets with which they could use to fight the new regime, or just continue living lavishly.
Topping off all of this economic dysfunction is the weak banking sector. Hundreds of banks sprang up in the 1990s, but these were not vehicles to help customers save, or to connect investors with businesses in need of capital. Rather, these banks existed to help facilitate various types of financial schemes and capital flight operations. As a result, the banking sector remained highly unstable, and average bank savings would be wiped out when these banks collapse.
The reasons for Russian capital flight are manifestly clear. The lack of rule of law allows inefficient and corrupt public policy and bureaucracy to flourish, which in turn hampers development of an institutionalized business environment and seriously undermines property rights. Ordinary citizens and political leaders alike recognize these institutional shortcomings of the Russian system, and therefore try to move their money overseas into jurisdictions with strong rule of law and property rights. This demonstrates that in addition to Platonic ideals of justice, the rule of law serves a serious purpose in ensuring the functionality of institutions.
 Stephen Kotkin, Armageddon Averted: The Soviet Collapse, 1970-2000 (Oxford UP, 2001), 139; James M. Boughton, Tearing Down Walls: The International Monetary Fund, 1990-1991 (International Monetary Fund, 2012), 300.
 Kotkin, Armageddon Averted, 132.
 Michael Ellman, “Russia’s Current Economic System: From Delusion to Glasnost,” Comparative Economic Studies 57 (2015): 695.
 Alena V. Ledeneva, How Russia Really Works: The Informal Practices That Shape Post-Soviet Politics and Business (Cornell UP, 2006), 100-10.
 Brian D. Taylor, The Code of Putinism (Oxford UP, 2018), 131-65.
 Ledeneva, How Russia Really Works, 159-63.
 Ledeneva, How Russia Really Works, 177-88; Ellman, “Russia’s Current Economic System,” 696-99.
 Karen Dawisha, Putin’s Kleptocracy: Who Owns Russia? (Simon & Schuster, 2014), 317-18.
 Anders Åslund, “The Problematic Nature of Russian Banking,” Demokratizatsiya: The Journal of Post-Soviet Democratization 27, no. 4 (2019): 426-28.; Ledeneva, How Russia Really Works, 142-43.