The Crunch Points:
How Russia Staggered
From There to Here
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Some Astonishing Missteps
Helped Grease the Slide
Toward Financial Ruin
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Mr. Gaidar's 'Terrible Choice'

MOSCOW -- For Vladimir Potanin, a tycoon now scrambling to keep afloat an empire that embraces banking, oil fields and a nickel smelter, the rot set into Russia's reforms a year ago with a brawl over a phone company.

Iosif Bakaleynik points instead to the years he struggled to drag a Russian tractor factory up to free-market speed. The lessons he had learned at Harvard's business school were ill-suited to Russia's treacherous terrain.

And for Yegor Gaidar, hindsight ranges over decades. The plump, squeaky-voiced economist who crafted Russia's exit from Soviet central planning in the winter of 1991-92 believes it was 70 years of communism, more than anything else, that hobbled the nation's rush to reform.

In the wake of Russia's financial debacle, the soul-searching over what went wrong runs as deep as the country's debts. What became of the promise engendered by the toppling of the Soviet Union is much more than a history or economics lesson, or an exercise in finger-pointing. The answers will guide the policies Moscow pursues in the coming critical weeks and months, how governments from Brasilia to Beijing will confront their own woes, and what, if anything, the West can do to help.

As the country gropes for direction after defaulting on its domestic debt and devaluing the ruble, basic questions arise: Was it wrong to believe that Russia could be so rapidly reconstructed? Is there something unique in Russia's history inimical to market economics? If so, do current events mark the end of another spasm of Westernization and the start of a slide back into Russia's own insular and authoritarian past?

A chronicle of the past seven years shows that the Russian reform effort, wildly ambitious in both scope and pace, suffered from a string of costly miscalculations. It was built on wobbly presumptions -- among them, that old state enterprises could become modern corporations -- and half-measures and compromises born of the country's struggle with its communist legacy. Corruption flourished, while efforts to establish fundamental laws and regulations withered. Inexperienced ministers drifted from indecision to bad decisions. Viktor Chernomyrdin, prime minister from 1992 until last March, provided perhaps the best summary of Russia's reform experiment, commenting on one of the country's earlier crises: "We had wanted the best, but things turned out as always."

The new prime minister, Yevgeny Primakov, a former foreign minister lacking any economic credentials, has put economic policy making in the hands of Yuri Maslyukov, onetime head of the Soviet planning agency Gosplan. The dangers are obvious: Russia has moved far enough since 1991 that the old system cannot be rebuilt; but the system remains close enough that some fragments of the past can be retrieved and pieced back together.

At the height of his authority in 1993, President Yeltsin mused on the failed reforms of czars and general secretaries. "Peter the Great's reforms have not been achieved to this day," he said. Nor have "Lenin's new economic policy, Stalin's industrialization and Khrushchev's thaw . . . changed anything fundamental in Russia."

His own attempt, he declared, would be different.

Where it was unique was the scale. The unraveling of the Soviet Union forced Russians to redraw their borders, both mental and geographic. History, it was said, had come to an end. Russia was its terminus.

When Mr. Gaidar freed prices in January 1992, he told the Russian people to brace for severe pain but promised that their suffering would be rewarded. The past had to be dismantled swiftly, he said, to ensure it would never return. Ever since, Russia and its backers in the West have lived this idea: Fortified by democracy and billions of dollars in aid, the nation would join the advanced world.

Russia's reformers saw themselves as agents of capitalism's inevitable triumph, not politicians selling a program to the masses. Brigitte Granville, a French economist who worked with the reformers from the beginning, recalled a 1993 meeting with many of the leading liberals and officials from the International Monetary Fund and the World Bank. She worried about the impact of reform on ordinary Russians and proposed a social-safety-net loan to cushion the blow. One of the Russians immediately scolded the foreign group, saying, "I didn't know you had a Marxist on your team."

The government made enemies even of the country's most energetic entrepreneurs, the so-called shuttle traders who bought cheap goods in Turkey, China and Dubai for sale in Russia, by saddling them with onerous taxes and duties.

As reform began to bite, many Russians perceived democracy and the free market as their new enemies. The disenchantment was especially deep among some of the country's keen young managers and the workers they tried to convert.

Mr. Bakaleynik, the Harvard graduate, returned to Russia in 1994 after a two-year stint with the International Finance Corporation in Washington and became a pioneer of Russia's privatization program. Backed by a Moscow bank, the then-43year-old businessman gained control of a tractor factory in the town of Vladimir, 120 miles northeast of Moscow. At a meeting with his thousands of workers in a local football stadium, he echoed the words of Mr. Gaidar, warning that "the market is cruel" but also that it would reward those willing to work hard.

For three years, he struggled with overstaffing, outdated equipment and a government more interested in macroeconomics than in the nuts and bolts of change on the shop floor. Last year he gave up. He had slashed his work force to 5,000 from an initial 13,000, but mainly because his markets dried up. Output slumped to 1,800 tractors a year from more than 8,000.

Looking back, Mr. Bakaleynik blames the gap between theory and practice for many of his woes. "The idea of the invisible hand doing the job in two or three years," he says, "was not workable." Instead of nurturing the revival of ailing factories, the government crippled industry through corruption, taxes, shifting policies and monetarist dogma that strengthened the ruble but strangled exports. He left the plant last year and became an oil-company executive in Moscow.

The muddle that came to characterize Russian reform began, oddly, with a decision of uncompromising clarity. By freeing prices only days after the collapse of the Soviet Union, Mr. Gaidar took a wrecking ball to the central tenet of central planning. Fixed prices had smothered incentive to either produce or sell. The only other way to put goods on store shelves was to revive the political terror that had sustained the command economy. "Either you started shooting or you liberalized prices," recalls Mr. Gaidar.

The economic impact was immediate. Prices rose by over 2,000% in 1992, and shop shelves filled up. The political impact was also swift. Their savings wiped out and the rubles in their pocket nearly worthless, many Russians blamed their pain on the country's young reformers, not the communist system that had created the problem.

The communists themselves began to regroup, after being routed the previous year when Mr. Yeltsin defeated a hard-line putsch. Coal miners, who only a few months earlier had been in the vanguard of support for Mr. Yeltsin, staged protests. Impoverished pensioners, many of them reduced to hawking stale Soviet-era cigarettes and old clothes on the street, joined small but angry demonstrations.

For Mr. Yeltsin, who had been basking in the approval of Western leaders and the lingering warmth of public regard that helped him unseat Mikhail Gorbachev, this was the first major challenge. Establishing a leadership style rooted in populism and frequently shifting between boldness and retreat, sickness and health, Mr. Yeltsin flinched this time. He fired Mr. Gaidar and replaced him with Viktor Chernomyrdin, the former head of the gas monopoly now known as RAO Gazprom, who immediately called for an end to Russia's market "bazaar."

Relations between Mr. Yeltsin and the parliament festered in a series of confrontations, and the legislators' opposition soon hardened into hostility. In late 1993, Mr. Yeltsin dissolved the parliament and ringed the chamber with barbed wire. When legislators rebelled, he broke them by sending tanks to shell the parliament building.

Underlying the conflict was a fundamental clash over economics: Should the state spend its money to prop up industry, and who should own property? Moscow only fueled the debate with its other major reform step.

If price reform aimed to put bread in the stores for the short-term, privatization was the long-term plan for turning around the economy. The idea behind the program was the product of a freshly minted theory: transfer ownership from the state to workers and managers to give them a stake in success; issue shares that Russian entrepreneurs would use to take over companies and make them profitable; instead of draining money from the state through subsidies, factories would instead help finance the government with taxes.

The theory's champion was Anatoly Chubais, then head of the State Property Committee. Like Mr. Gaidar, he spoke not only the language of free markets but also English. In them, the West invested its hopes for Russia.

In late 1992, the government launched the mass privatization program by issuing 144 million vouchers that entitled nearly every Russian to secure shares in newly privatized firms. The scheme was ingenious -- democratic in its original conception and conducive to the formation of a new industrial elite. But like many other good reform ideas, it mutated.

Entrepreneur Andrei Volgin was one of the first to try putting the theory of privatization into practice. He took over five state-run enterprises, but he achieved only mixed results. For a bread factory in Vladimir, in which he secured a 46% stake, Mr. Volgin says he needed only half the 600 workers. The plant's management and local government resisted cuts. The general director gave himself a loan to buy an apartment.

What the director did in his factory, the men who should have been Russia's Rockefellers, Mellons and Carnegies were doing on a far larger scale.

Privatization raised the profile of a group of new tycoons known to the Russians as the "oligarchs." Back when the Soviet Union fell apart, they set up banks and used them to help the government pay its bills. The state funneled billions of rubles through their hands. As a stop-gap measure, the arrangement made sense for a government that hadn't yet set up a treasury system. But instead of lending money to entrepreneurs, banks used the government funds to make bets on the ruble and bond markets.

"The 10 biggest banks went to the casino and put Russia on the table," says Mr. Volgin. "They lost."

Alexander Smolensky, president of SBS-Agro, Russia's largest private retail bank, derides talk of an oligarchy, saying, "The richest people here are the bureaucrats." He blames these officials for the financial crisis, which has broken his bank. Surrounded in his headquarters by oil paintings and other trophies of earlier success, he has defied an attempt by the Central Bank to place his enterprise under state administration. A 44-year-old former printer and construction manager, Mr. Smolensky dismisses Messrs. Gaidar and Chubais as "laboratory assistants" in an experiment gone haywire.

Even as Russia's financial collapse has pushed some of the tycoons to the wall, they still have connections. Mr. Potanin, for instance, is struggling with foreign creditors to salvage what remains of the banking arm of his Interros financial and industrial group. But he can point to three yellow telephones on his desk that give him direct access to the government's communications network. "This one is for the big officials, this is for the smaller ones and this is for the governors," he says.

Ahead of parliamentary elections in 1993, the emergent business elite helped finance the campaign of reformist candidates led by Mr. Gaidar. It was a critical time for domestic banks, coinciding with a push by foreign competitors to enter the Russian market. Even before the poll results were in, the government showed its gratitude by blocking the competition.

Despite spending far more than the communists and a party of pugnacious nationalists led by Vladimir Zhirinovsky, however, Mr. Gaidar's party secured only 16% of the vote. Mr. Chernomyrdin sniffed a shift in the prevailing winds of reform, immediately declared an end to the era of "market romanticism," and tried to reimpose some price controls. Although he soon abandoned that plan, he did allow another relic from the past, a group of Soviet-era factory directors, to reassert some of its influence.

Meanwhile, the bargain the state had struck with its bankers stuck, and paved the way for others. It was a cozy setup that took on many forms. Mikhail Khodorkovsky, who founded Bank Menatep, one of Russia's top 10 banks, when he was in his twenties, has described Russia's prime minister as "my boss." Sometimes, though, it was hard to tell who was really in charge. When the ruble crashed in 1994, Mr. Khodorkovsky picked up the phone and persuaded Mr. Chernomyrdin to pressure the Central Bank to inject cash into the banking system.

The most controversial bargain came in 1995. In December of the previous year, President Yeltsin had launched a brutal war against the breakaway republic of Chechnya that killed more than 50,000 and drained as much as $5 billion from state coffers just as the country's finances were beginning to stabilize. The huge outflow of public funds tightened the embrace between the state and a few well-connected businessmen. Desperate for cash, the government mortgaged some of its most lucrative assets for a fraction of their real value in return for loans from a handful of bankers. Meeting in secret, they carved up the spoils. Government bureaucrats colluded in the so-called loans-for-shares deals, allowing ownership of the stock-in-trust to be awarded at rigged auctions.

There wasn't even a semblance of propriety. At a news conference in 1996, a Menatep executive could hardly contain his laughter when he claimed, implausibly, that he didn't know who owned the subsidiary that had just bought Yukos, Russia's second-biggest oil company. Russian journalists, served cognac by the bank's staff, guffawed in disbelief. Menatep had run the auction and the bank, it would later disclose, controlled the firm that entered the winning bid.

Beneath the jaunty confidence, though, lurked a constant fear that the state might reclaim what it had relinquished. Mr. Khodorkovsky often joked to associates, "I don't own anything. I rent it."

To protect the lease, the bankers banded together. In 1996, Russia's tycoons went into overdrive in support of Mr. Yeltsin's successful re-election campaign against his communist rival Gennady Zyuganov. As well as providing funds, they mobilized their media interests -- newspapers and television -- to serve Mr. Yeltsin's campaign. Boris Berezovsky, a former mathematician who had parlayed a car dealership into one of Russia's biggest personal fortunes, was frank about his motives. If Mr. Yeltsin won, he said of his tennis partner and friend, "maybe my assets are worth billions of dollars"; if he lost, "maybe nothing."

All the while, the government was going broke. It couldn't collect the taxes it needed to pay its bills. So it built a rickety structure of domestic and foreign debt, creating the pyramid that collapsed in August and pushed Russia into default.

The speed with which the edifice crumbled reflected the speed with which it had been built. From the start, Russian reformers and their Western advisers wanted to move quickly, believing that financial markets, no matter how imperfect their construction or regulation, would entrench change and begin to work their magic on Russian enterprises and the economy. The West contributed billions of dollars and Russia quickly had a secondary market for stocks and bonds.

Foreign investors piled in. At one point, 80% of all trade in the stock market was from offshore investors. Bernard Sucher, one of the founders of Troika-Dialog brokerage house in Moscow, heard a knock on his door at 4 a.m. one day in 1994 from a drunken foreign hedge-fund manager desperate for a fix. "He said it didn't matter what stock or what price. He just had to have more."

The stampede blinded investors to the reality behind glossy brochures and lavish road shows. Russian accounting practices warped losses into profits. Regulation was virtually nonexistent. Companies diluted stockholding at will and trampled the interests of minority investors. The Russian Securities Commission had a mandate to prevent this and dollops of Western aid, but no real power.

The Central Bank fared no better in imposing order. Its chairman, Sergei Dubinin, claimed last year that $500 million in government bonds had been improperly diverted through two commercial banks. A week later, an unidentified gunman opened fire on Mr. Dubinin's home. (No one was hurt.)

According to Mr. Potanin, though, Russia's crisis sprang not from this chaos but from an attempt by the government to enforce some rules. A critical turning point, he says, was last's year's auction of the telephone company Svyazinvest. Embarrassed by the furor over loans-for-shares deals, the government organized a relatively fair and transparent sale. Forced to compete, instead of collude, Russia's barons went to war. Destroyed in the hostilities was the nonaggression pact that bound government and business together. The sale, says Mr. Potanin, was "100% correct, but led to disaster."

For all the shortcomings of reform, Russia still managed, on one level, to get things almost right. By last year, basic economic indicators held out the promise of recovery. Inflation had been tamed, the ruble was stable and gross domestic product grew for the first time in a decade, albeit by only 0.8%. Mr. Yeltsin defied the odds once again, surviving quintuple-bypass surgery and double pneumonia. The press and politicians pointed to the rising anger of workers over unpaid wages, which had ballooned to more than $10 billion. But predictions of widespread chaos in the streets and industrial unrest came to nothing.

Upon returning to the Kremlin in the spring of 1997, Mr. Yeltsin brought a clutch of reformers into the government. With parliamentary elections two years away, they had a rare opportunity to take tough decisions previously dodged -- such as cracking down on tax deadbeats, accelerating bankruptcies and laying off workers.

In December 1997, a special commission headed by Mr. Chubais to collect taxes decided to seize and sell the assets of two provincial oil refineries belonging to the empires of Mr. Berezovsky and Mr. Potanin. The tycoons, however, marshaled their forces, and a week later, with Mr. Chernomyrdin chairing a meeting of the commission, the decision was overturned.

A cascade of accidents, bad luck and blunders followed. The price of oil and other commodities that provided more than two-thirds of Russia's hard-currency earnings began to plunge. Mr. Yeltsin shattered the political equilibrium by abruptly firing Mr. Chernomyrdin and naming a 35-year-old political neophyte, Sergei Kiriyenko, as prime minister. The financial maelstrom that had begun in Asia the previous summer looked around for its next victim and found Russia, after seven years of muddle, ripe for disaster.

The International Monetary Fund and other lenders rushed in with a promise of $22.6 billion to try to break Russia's fall, but investors' confidence continued to plummet. As Russia's markets crumpled, Mr. Gaidar, Mr. Chubais and other no-longer-so-young reformers who had laid their foundations years before came together for a last desperate attempt to preserve what they had tried to build. On the weekend of Aug. 15-16, they huddled together in the White House, the seat of the Russian government. Also there were Mr. Potanin, Mr. Berezovsky and most of Russia's other business barons. The IMF's senior Russia expert had rushed to Moscow to add his voice, but left his checkbook in Washington.

Mr. Gaidar, though long out of office, found himself confronted with "a terrible, unpleasant choice," almost as fateful as the one he faced when the Soviet Union fell apart. Reformers, he says, had for years feared such an across-the-board financial collapse. Now it had come. "It was our worst nightmare," says Mr. Gaidar.

On the morning of Aug. 17, Prime Minister Kiriyenko and Central Bank Chairman Dubinin announced the result of the weekend conclaves. Russia would default on government debt, devalue the ruble and impose a moratorium on the repayment of foreign private debt.

As so many times before, the government wanted to offer something for everyone, except for foreigners who had no political clout. This time, though, the attempt at compromise led to disaster. The currency sank; the banks became insolvent; and the government ruined, probably for years, its ability to borrow. A week later, Mr. Yeltsin sacked Mr. Kiriyenko, Mr. Chubais and their colleagues. Instead of saving reform, Russia's reformers ceded the initiative to the communists. The new government headed by Mr. Primakov is now groping for a third way between the familiar tensions of the state vs. the market, economic populism vs. austerity, and Russian answers vs. Western solutions.

The man who launched Russia's reforms still clings to his convictions and believes the country, after another failed search, will return to his path. Says Mr. Gaidar: "I'm absolutely sure that I'm right."