RD Interview: Alexander Auzan, dean and professor at Lomonosov Moscow State University's Faculty of Economics, discusses the major challenges facing Russia's economy, including a potential brain drain, slumping oil prices and the difficulties of modernizing an economy dependent on natural resources.

"When people talk about the “innovation storm,” it should be remembered that for wide-scale innovations to emerge, difficult circumstances are not enough. You need a sound institutional environmen". Photo: RIA Novosti

With the economic crisis in Russia showing no signs of abating and the ultimate impact from geopolitical instability on the country’s economy still to be seen, Russia Direct sat down with Russian economist Alexander Auzan, a member of the country’s Economic Council and dean and professor at Lomonosov Moscow State University's Faculty of Economics.

The interview ranges from domestic economic and social problems to international economic issues – everything from the downgraded sovereign rankings of Russia to the nation’s "brain drain" and turmoil in the global energy markets. In addition, Auzan sheds the light on the so-called "mobilization scenario" for the development of the Russian economy.

This is a term that Auzan and his team of economists came up with last year to understand the most likely development scenario for Russia. In his earlier works, Auzan also described the “liberal” and “inertia” scenarios. While the former boosts the investment climate and creates high-quality institutions to attract foreign investment, the latter is confined with half-measures and preserving the economic status quo without drastic changes.

Of the three scenarios, the mobilization scenario is the most likely, Auzan predicts. This scenario shifts its focus from foreign investment to state investment and, thus, further isolation of Russia's economy from the West.

Russia Direct: On Feb. 20, rating agency Moody's downgraded Russia's sovereign ranking, a month after Standard and Poor's lowevered the country to "junk" status. Last month, some representatives of Russia's Duma proposed banning these agencies from working in the country. These officials claim that the world's rating agencies "purposefully downgraded Russia's economic record." To what extent can this idea be true and what are its implications? In particular, does it mean a turn to the mobilization scenario of Russia's economy?

Alexander Auzan: When people start talking about ratings, they forget that they are customized for specific purposes. In other words, they are addressed to specific market players to help them make a decision. As for international ratings (despite the problems with the changing methodologies and the subjectivity of the experts who devise them), they are seen as a guide for investors.

Therefore, if we stop paying attention to the ratings, it means that we have lost interest in investment from other countries, and in this case, not only from countries that are closed to Russia due to sanctions, but also from those that are not closed (but which will nonetheless look at the ratings to see what is happening). So what source remains? Public investment. That’s what I call the “mobilization lite” optionpublic money can be used to build a way out of the crisis and grow the country’s economy.

RD: But what specific implications can this scenario (“mobilization lite”) have on the country's investment climate, given the current economic volatility and geopolitical instability?

AA: It will be doubly reflected in Russia’s investment appeal, because the climate is, of course, deteriorating. The main factor here is not the pull of the climate, but the magnet of public money. It cannot be ruled out that there will be public-private partnerships, including ones with foreign money and foreign capital, and not necessarily European or American capital. This capital could be from South Asia, the Arab world or China. I would say that this option is bad for large-scale investment because it is not geared towards improving the investment environment - it only contains magnets that can attract gold dust.

RD: Previously, you said in one of your interviews that the mobilization scenario might be implemented in the form of “currency controls.” If it finally happens, what does it mean for business and those foreign investors who are still dealing with Russia?

AA: “Currency controls” essentially result in a situation in which everyone is let in and no one is let out. People are reluctant to visit a place if they don’t know when or on what terms they’ll be allowed to leave. So, of course, it’s bad news for both those who, for whatever reason, were pondering the idea of coming to the country and those who find themselves here already. However, those who stayed in the country, if they feel uncomfortable about the introduction of currency controls, will start removing capital according to new rules.

Although I wish to emphasize regarding the mobilization lite scenario, I am not a strong believer in radical currency controls. First, it would be unlikely to affect the population at large (conversion restrictions, etc.). We’re talking about larger amounts. Second, I do not think that it will be question of un-pegging the ruble from the dollar or euro, etc. I doubt it because we still sell our main commodity, oil, for dollars; that’s why we are attached to it, not through our policy decisions, but by our economic situation.

Therefore, I expect our foreign exchange control measures to be moderate. But I don’t know when they will come. It might not be all that soon, since the current government and the Central Bank are clearly not bent on taking such measures — they don’t want them because they know they’ll cause heartburn and will have negative consequences alongside the positives for market regulation.

Alexander Auzan (right) discussing Russia's influnetial economy with Sberbank Head Herman Gref (left), and Andrei Belousov, Russian economist who serves as Assistant to the President of Russia (middle). Photo: RIA Novosti

RD: Some economists warn against social unrest amidst the economic meltdown. From your point of view, to what extent are social protests possible in 2015-2017, especially if there is an aggravation of the economic crisis? What sort of social policy should the Kremlin conduct to prevent or alleviate these protests?

AA: Social unrest is certainly possible, and in my view, could happen fairly soon: The current inflationary spike and declining employment is set to continue over the coming months and will cause public discontent, to put it mildly. Looking further ahead, the question will be how to respond.

There are different options. One is to replay 2008-2009. First, the situation was resolved by a manual approach - we apply special measures where the blaze is most intense. Second, people’s incomes were given a major injection. The salaries and pensions of state employees were raised. It had a positive impact economically by facilitating an exit from the crisis, since it was essentially about pumping up demand as one of a number of anti-crisis measures.

In the medium term, however, it was very bad, since the economy was heavily weighed down and forced into all sorts of not overly successful measures, beginning in 2009 and ending in 2013-2014: social taxes were raised, the accumulative pension system was wound up, etc. I don’t think this policy should be repeated and, besides, the resources are lacking.

Today, I think indexing [salaries of civil servants and other state employees] will be necessary, despite the objections of the Finance Ministry. Indexing will have to be carried out because we haven’t seen such a huge hike [in inflation] for 15 years, since 1999.

What’s more, from my perspective, what I was trying to convince the prime minister of is the need to save human capital in times of crisis and to make investments in human capital more effective through education and health. This funding must not be cut. It is indeed a huge headache for the government, because investment in human capital does not give a multiplier, at least not in the foreseeable ten-year period, but right now they are looking for a quick multiplier — either by pumping up demand or investing in infrastructure.

This, incidentally, is a good thing, particularly for social issues, because investment in infrastructure increases the options available to small and medium-sized business. This is a very good and highly absorbent medium for solving the problems of unemployment and for self-employment.

This option is essentially about social policy: If you build roads and other infrastructure that helps business grow (which is important in a crisis), jobs get created in the process. It is by no means a technological revolution, but is still directed towards the future and gives some relief.

RD: Taking into account the case of Russian entrepreneur Vladimir Yevtushenkov whose assets in the Bashneft oil company were appropriated by the government, can we talk today about the Kremlin's plan to reassess the results of privatization during the 1990s - or will it stop at this case?

A.A.: The bottle is openand the genie can come out. I can’t say there’ll be a wholesale confiscation of assets — that’s not how it is. But neither can I say that it’s an isolated incident and will not happen again. The precedent has been set.

RD: From your point of view, what fields of Russia's economy are most eligible to invest today, in a time of economic crisis and unpredictability?

AA: With regard to industries, I have a mantra that I constantly repeat: When it comes to development options for Russia, for some reason the focus is always on our mineral resources and not on the fact that the country is inhabited by people with a particular culture, psychology and habits. Looking at the socio-cultural condition that we’ve grown to know and understand, we can say that Russia is poor at making mass-produced products and significantly better at producing things that are unique and “limited edition,” so to speak. Against this cultural backdrop I believe that now, as at other times, it would be wise to invest in pilot production, the creative industries and non-mass production of specialized equipment, etc. Elsewhere it depends on the situation.

As a result of plummeting oil prices and controversial policy of Russia's Central Bank, ruble became weak and extremely volatile. Photo: AP

RD: Given the fact that the Russian authorities tend to see the crisis, falling oil prices and sanctions as an opportunity for modernizing the country's economy, will Russia be really able to use the crisis as leverage for innovating its economy?

AA: I don’t think so, because when people talk about the “innovation storm,” it should be remembered that for wide-scale innovations to emerge, difficult circumstances are not enough. You need a sound institutional environment, namely, legislation, health care, courts, intellectual property protection. While it cannot be said that we haven’t tried to build this environment, neither can we say that we have. Therefore, my assertion is that the changes in the structure of the Russian economy will certainly have a positive value and produce a certain amount of diversification, but there can be no “innovation revolution” during a crisis.

RD: So, what is to be done to minimize the negative consequences of the current crisis, if we have neither a proper national economic environment, nor the right institutions?

AA: As for the positive aspects that could come out of the crisis, I expect to see changes in Russia’s outlook on the future. What the 2008-2009 crisis failed to teach us was that there is no return to the previous raw materials-based economic model (although economists and drafters of the 2020 strategy said in unison that we cannot get out of the crisis through the same door that we got into it). Nevertheless, the government attempted to establish a status quo after the crisis. We suffered a slowdown.

The slowdown, by the way, began in 2011. There were no serious geopolitical tensions back then, no falling oil prices (on the contrary, they were rising), yet the economy stalled. It was the previous model becoming depleted. The investment engine began to sputter, so a different model is needed.

In my view, on top of everything else, we need to steer the economy away from dependence on raw materials towards an economy dependent on high-quality human capital. After all, Russia has two competitive advantages. Everyone knows about its natural resources, but everyone also knows that we’ve been supplying the world with brains ever since Russia put in place a decent system of education and scientific training. And this resource is in fact more productive than oil. You know, some calculate that Vladimir Zworykin, who invented television, produced an economic effect equivalent to 20 annual products of today’s Russia. I think that Sergey Brin, co-funder of Google, has produced something on the order of 5 to 7.

There were times when we destroyed such people, and now they are out there in the world making a Russian contribution to global development...

RD: On the other hand, there is brain drain from Russia. The Ukraine crisis, economic instability and the political regime can only further spur the intellectual outflow. How to deal with it? Are there some contradictions between claims that Russia can feed the world with talented people and their desire to leave the country?

AA: First, even if people leave, it does not mean that they sever ties with their country, because I can cite numerous examples of brilliant people at my own economics faculty. For instance, Oleg Itskhoki, one of the top 10 young economists in the world, works from Princeton with our students and sometimes visits us. He’s not alone.

Second, the obvious conclusion under the mobilization scenario is that we will lose our intellectuals. Who might be interested in working in such conditions? Probably, it is someone who lands a job in the military-industrial complex, with all the associated restrictions on him and his family. Such a person swaps freedom of movement for vertical mobility: horizontal mobility is traded for vertical. I don’t think there’ll be many such people.

Third, I feel we should talk about how to steer away from natural capital towards human capital, and generally pose the task in a different way and build other institutions, because our institutions facilitate the extraction of materials. Right now we have extractive institutions: they create the situation for grabbing and squeezing things from the soil, which are utilized in other countries where the institutions are inclusive and where people live well. So basically we have to start creating inclusive institutions, unless we want our brains to run off...

RD: ... and come back...

AA: ... yes, and come back. For that the country needs internal appeal, not just a high level of profitability, because a highly profitable country will attract adventurers, even at a time of sanctions and political twisting and turning, since the greater the risk, the greater the premium. But the brains that sprout here will not stay. Therefore, lessons must be drawn and a new policy framed right now.

RD: As you mentioned in your earlier interviews, Russia's anti-crisis measures in 2008-2009 did not give a sustainable economic model "with which the country could live further." This echoes with the words of the Russian Minister of Economic Development, who also said that Russia's authorities lack strategic economic vision. Given the volatile geopolitical and economic situation and, particularly, the so-called "black swans" or unpredictable factors, does the discussion of the Kremlin's lack of strategic planning really help today?

AA: Let’s understand where the strategic thinking originates. In principle, the government’s thoughts about self-preservation are quite normal: Any authority thinks about self-preservation. The question is: Over which time horizon does it imagine itself and the country existing? That’s why for me, people differ not according to their views, but according to the length of time in question, because a liberal, conservative and socialist can agree among themselves if the time frame is 10 years.

The country’s elites do not necessarily have to think long-term, because they can use other countries’ institutions for themselves: keep their money in Switzerland, send their children to school in England, and derive revenue and govern in Russia.

These days, in an atmosphere of geopolitical tension, they [the elites] are finding it much harder, and therefore they may have to think about making do here, or leaving. Oddly enough, the problem is the same in any country: The elites always use global institutions — and the people national institutions.

Therefore, the question of where the elites take their long-term view is a tricky one. From where can they take it? Either from the fact that they intend to hold on to power for a long time, as in, say, a monarchy that passes power from generation to generation, or because they have large and immobile assets in the country that need to be controlled, and therefore people have to somehow live around them and their social problems must somehow be addressed.

Each of these factors has played a certain role in Russia at different times, because when the oligarchs were strong, their large industrial assets were a major factor in the social value of urban areas and the idea held that property would be passed on [by inheritance]. Incidentally, this problem has not gone away: We are facing a generational change, which means the older generation is agonizing over how to transfer its legacy to the next...

RD: ... and to whom specifically...

AA: ... to whom and how, and what will be left over for the state, what will be seized, what needs to be transferred to non-profit foundations... The transfer of inheritance is a stimulus that encourages us to think about the long-term.

RD: In a recent interview, you said Saudi Arabia launched the war of redrawing the contours of the oil market as a move against the U.S. innovation economy and the shale revolution. You said this war might end in "an absolutely unpredictable way." Could you be a bit more specific in your forecast?

A local contractor at the Range Resources hydraulic fracturing operation in Claysville, Pa. Photo: AP

AA: I still think that the Saudis are not at war with Russia in collusion with the United States (as is believed to have been the case in the 1980s): the rapid development of shale and falling demand caught the Saudis off guard. The economic slowdown in China and the recession in the euro zone created a convenient situation to conduct a competitive war for the closure of wells and the bankruptcy of projects.

On the other hand, I do not accept that either the United States or Europe is ready to surrender the innovation economy, which is the main resource of developed countries against newly industrialized ones. The United States will look for ways to preserve its innovative oil industry.

Fears that the Saudis could put an end to shale oil are unfounded. The technology is out there and has been proven to work, so we can only talk about the pace and conditions of development. Plus, during political negotiations not only economic issues are on the table, but also the situation in Syria, ISIS, politics, etc.

The exit will be unexpected because when it becomes a subject of political negotiations there’ll be trade-offs and exchanges. And once that happens, there can occur sudden changes in the price dynamics of oil. I don’t think it will climb back to its previous level of $110 per barrel, but I believe it will be higher than today’s $60.