Ukraine: How Not To Run an Economy

Fortune issue: June 12, 2000

First Principles

Ukraine: How Not To Run an Economy

By N. Gregory Mankiw

In this world there are two ways to get rich. No. 1: Produce something valuable and sell it to others. No. 2: Find people pursuing the first strategy, and steal from them. On a recent trip to Kiev, I was reminded that a nation achieves economic prosperity only when it makes the first strategy more profitable for its citizens than the second.

Like many countries of the former Soviet Union, Ukraine is struggling to make the transition to a market economy. It hasn't been easy. GDP per capita is now about $1,000, or about 3% of the U.S. level. By this measure, Ukraine is no richer than China - and in some ways is in worse shape. Average Ukrainian income has fallen by half over the past decade.

Corruption is a large part of the problem. The police regularly shake down foreigners for cash. Doctors won't provide the supposedly free health care unless patients make side payments. Businesses hide much of their sales to avoid paying the country's high taxes. As a result, the government finds itself without enough revenue to make good on all its commitments. Many government workers go for months without being paid, except for the bribes they receive on the job.

McDonald's are all over Kiev, but other U.S. businesses are notably absent. Starting any profit-making enterprise in Ukraine requires the cooperation of many government officials whose self-interest is never far from the surface. One Ukrainian who helps Western businesses in the country told me that 20% to 30% of an investment project's budget should be allocated for bribes.

Paradoxically, Kiev is a safe city. You are more likely to be mugged on the streets of the U.S. capital than in the Ukrainian one. In the U.S., however, the economic impact of crime is minor; in Ukraine, crime is an organized activity of the elite, and it goes to the heart of how the economy works. While an ambitious young American finds wealth and status by starting his own dot-com, an ambitious young Ukrainian aspires to become a corrupt oligarch.

There is no limit to how high the corruption goes. News reports indicate that Pavlo Lazarenko, Ukraine's Prime Minister until 1997, allegedly transferred more than $250 million from public funds to Swiss bank accounts before leaving the country on a Panamanian passport. According to these reports, he is now in the U.S., fighting extradition on charges of money laundering and embezzlement. After arriving here, Lazarenko bought a 41-room house from actor Eddie Murphy for $6.75 million. Most Ukrainians, meanwhile, live in the small, crowded, decrepit apartments built during the Soviet era.

The biggest obstacle facing Ukraine - and many other struggling economies around the world - may be a destructive and self-perpetuating set of social expectations. In the U.S., we expect entrepreneurs to be well rewarded and corrupt officials to be punished. By contrast, Ukrainians expect entrepreneurs to lose much of their profits to corrupt officials, and graft goes unchecked. The expectation helps create the reality. In a society where everyone expects rampant corruption, each corrupt individual feels outside the reach of the legal system.

The country's future isn't necessarily bleak. In some ways Ukraine resembles the New York City of the late 19th century, when city bosses in Tammany Hall lived on bribes and kickbacks. The bosses were not invincible, however, and middle-class democratic reformers eventually pushed them out. Today corruption is the exception rather than the rule in the U.S. - a fact that helps propel our prosperity. With more than a little luck, that's the model that Ukraine and the rest of the former Soviet Union can hope to follow.


N. GREGORY MANKIW is an economics professor at Harvard and the author of Principles of Economics.