Protection Rackets

The NYTimes reports about Oleg Deripaska suing Vedomosti over disclosure of financial information. The key points:

Rusal, the world’s largest aluminum company, is closely held by wealthy Russian businessmen, including Oleg Deripaska, once Russia’s richest man. As a private company, few details of its business are public.

The company hopes to raise $2.5 billion in an initial public offering in Hong Kong that will be an important test of international investor interest in Russian equities.

A series of articles in the business newspaper Vedomosti at the end of October detailed Rusal’s dismal financial results for 2008 and included other facts about the company. The articles cited documents given to bankers at a conference closed to the public.

That scoop is evolving into a legal test for business publications in Russia, a country where the political press is already kept on a tight rein.

Something appears to be missing in this story. Why is Deripaska doing this? Clearly, this lawsuit threat can have nothing to do with RUSAL’s impending IPO. The information that Vedomosti published is already published! A lawsuit, even if successful, is not going to put that genie back in the bottle. Moreover, Deripaska’s hypersensitivity about this can only serve to heighten suspicions that RUSAL really does have something to hide. In short, threatening a lawsuit is not in Deripaska’s immediate interest at all. So why is he making the threat?


The answer is that Deripaska is acting here not primarily on his own behalf but on behalf of all the members of the small club of oligarchs in Russia who – like Deripaska - participate in Vladimir Putin’s “protection racket.” Clifford Gaddy and I are writing in detail about this scheme in our new book, Russia’s Addiction. Beginning in the year 2000, when he entered office as Russia’s president, Putin has had a deal with the most powerful business owners. In that deal, the oligarchs agreed to abide by a few clear rules about their behavior inside and outside Russia; in return, Putin guaranteed them not only protection against expropriation by the state but also, and even more important, protection against each other. To be able to deliver on that latter guarantee, Putin has since 1999 at the latest preserved a monopoly on damaging financial information about the oligarch-controlled companies. That is, he and only he (along with one or two key associates) possesses the information, and he protects it from any leaks. Financial information is the nuclear weapons of Russia’s thoroughly opaque corporate elite. When Putin took over, the oligarchs were on the verge of all-out and all-destructive war against one another using such information. He ended the era of proliferation and brinksmanship and enforced a peace that has lasted to this day.


But if Putin’s power over the oligarchs rests on a monopoly of financial information, what could be more threatening to him and his system than independent collection – and release – of financial information? If independent media seek out the goods on the oligarchs, Putin's authority is dissipated. Ending internecine warfare among the oligarchs was the key event in the formation of the protection racket. The main terrain on which that war had been fought was ... the "independent media." Independent in quotes because, of course, the oligarchs owned the media and used it as weapons against each other. That is how kompromat was disseminated prior to Putin's accession. Putin took the media over to insure the oligarchs against each other. Deripaska’s threat against Vedomosti is intended to send the message to the press today not to upset the system Putin established a decade ago.

Protection Racket

Many people wonder why Putin is willing to engage in activities that seem inimical to Russia's economic interests. These comments tend to miss the point of what Putin cares about. Cliff Gaddy sends in this comment that has it exactly right:

People ask, Why would Putin allow this to happen? It is not in Russia’s or his own interest. Foreign investors will be discouraged, oil production will suffer, and so on. It doesn’t make sense.

Thinking in these terms confuses efficiency as seen from the economic point of view and what might be termed political efficiency. Putin does indeed desire economic efficiency, that is, continued production of resource rents. But his first priority is control of the use of those rents – political efficiency. And here, informal taxes have two big advantages for Putin. First, informal taxes can be collected and redistributed much more flexibly than formal taxes. He and his inner circle need to be able to channel resources to precisely the people and purposes they choose, when they choose. One might object that they can do that anyway with the budgetary flows (the formal taxes) at their disposal. But those flows are not nearly as flexible. Putin is very concerned about his ability to react flexibly to changing circumstances. He needs to call on key actors to channel resources quickly.

The second advantage of informal taxes is even more important. Informal taxation is a key component of the property rights protection racket – Putin’s mechanism for manipulating the behavior of the resource owners. The world of informal taxes is a world of quasi-legality at best. Keeping companies in that world gives Putin leverage. It is absolutely a good thing for Putin that companies engage to a controlled extent in various forms of illegal payments such as bribes, kickbacks, padded contracts, and the like. Precisely because the actions are illegal, they make the companies vulnerable to the tax authorities and the police. Paying informal taxes forces companies to violate laws. And that is the point. The evidence of their financial crimes is collected at the same time that their money or favors are collected. The individual chiefly responsible for this branch of “Russia, Inc.” is Putin’s no. 2, Viktor Zubkov. Since his days as founder of Putin’s Financial Monitoring Agency (a “financial intelligence service”, as Putin once described it), Zubkov has been the personal repository of information that can destroy any major company and any wealthy individual in Russia. He can see to it that real – not fake – charges are brought against anyone, at any time. This is the way the Protection Racket works. Informal taxation is at its heart.

In a ruling handed down by the United States Supreme Court in 1819 (“McCulloch v. Maryland”), Chief Justice John Marshall wrote the famous words that apply to any society: “The power to tax involves the power to destroy.” In today’s Russia, the discretionary power to informally tax is an equally potent instrument of destruction and, more important, of control.

Irony and Loyalty

The New York Times has an article about William Browders' troubles in Russia. Browder was one of the most prominent foreign investors in Russia. His fund, Hermitage Capital, had $4 billion under management. He was a champion for minority shareholder rights in Russia. In that capacity he stepped on some important toes. Since 2005 he has been unable to secure a visa to return to Russia.

The irony is that Browder (the grandson of Earl Browder, former head of the US Communist Party) used to be one of Putin's biggest cheerleaders. He argued that Russia needed Putin's strong leadership, and applauded when Mikhail Khodorkovsky was sent to jail in October 2004.

Browder's fate does might seem to reflect a lack of loyalty on Putin's part. But what it really signifies is the risk inherent in challenging the system Putin created for control and distribution of resource rents in Russia (see my article with Cliff Gaddy on Resource Rents and the Russian Economy for a discussion). Browder's calls for transparency challenged the fundamentals of the Putin system. That is why he lost his visa.