The Russian Mafia and its Impact on the Russian Economy

 

Jeffrey R. Hatcher

 

 

            Policy analysts have for years contended that the new Russian economy has fallen prey to the Russian mafia, which has influenced the development of the newly capitalistic economy.  The purpose of this paper is to shed light on the breadth of the mafia’s involvement in the Russian economy.  The evidence of mafia involvement in the Russian economy is vast.  The mafia’s impact on the fledgling economy is seen in small family owned businesses and the largest banks in Russia.  The fact that mafia dealings go unreported to international organizations or the Russian government presents a problem to those attempting to analyze the mafia’s affect.  Hence, the figures presented can only be estimates of the mafia’s effect upon the Russian economy.

            The Russian mafia presents a complex problem to Russia’s newly capitalistic economy.  The problem must be addressed or the mafia’s grasp on power in Russia will grow stronger and debilitate the economy even more.

            The Russian economy since the fall of communism has been in disarray - rampant inflation, a sharp decrease of the Gross Domestic Product, an increase of debt, and a large trade deficit.  These economic indicators show the problems of the Russian economy, but are they a true picture of the economic condition of Russia?  It is hard to know.  The reason lays in the hidden nature of the mafia and the enormous amount of money generated by the illegal activities.  The mafia, by taking money out of Russia unreported, impacts the economic figures generated by the government and international organizations such as the World Bank and the UN.  However, there are many anecdotal accounts and estimates of mafia involvement in the economy.

            The history of organized crime in Russia dates back to the revolution in 1917, when counter-revolutionaries rejected the communist principles.  The groups were composed of aristocrats, White sympathizers, and disillusioned revolutionaries[i].  They created informal rules of crime and bribed the Soviet officials.  Corrupting the ranking members of the government allowed the groups to gain power and access to means of production. 

A single person does not head the mafia in Russia; rather it is a large number of smaller organizations and a few large ones.[ii]  The scope of the mafia throughout Russia is enormous.  Arnaud de Borchgrave, the Director of the Global Organized Crime Project, estimated that there are 6,000 organized crime groups within Russia with 3 million members.[iii]   The organizations are primarily small ones, but in a few cases, they are large and powerful machines that can control the government and large industries.  The black market in Russia has always existed for those with the wealth, such as a butcher selling choice cuts of meat “through the back door” or better housing (constitutionally provided on the basis of need) that could be secured with a bribe.[iv]  The mafia has evolved into several highly sophisticated organizations with awesome power and influence. 

            The mafia, after the fall of communism, has played an increasingly detrimental role.  Converting the nation from a state-owned and operated system to a capitalistic economy has been a hard task for the government.  The privatization of state-owned property occurred on a massive scale without many legal safeguards.  This allowed the mafia, using their huge financial clout and political ties, to attain large amounts of property.  Recent estimates state that the mafia controls 40 percent of the total economy.[v]  Often the groups deplete the resources of the property and send the profits out of the country.  This brings about the central and most devastating problem associated with the Russian mafia – capital flight.

            Capital flight is funneling money out of the Russian economy.  This problem is not similar in other countries with mafias; often the money made from organized crime in countries such as Italy and Colombia is put back into the economy.  Regularly the capital flight in Russia occurs when the mafia deposits its illegal earnings in offshore banks and foreign countries.  Of the monthly capital flight, estimated to be $2 billion, at least 40 percent of it comes from mafia groups[vi].  That is over $19.2 billion dollars a year.  When one compares that to the Gross Domestic Product of Russia, $276.6 billion in 1998[vii], one sees how profoundly the mafia affects the Russian economy.  The impact is shown again: the percentage of capital flight as compared to the GDP is equal to the percentage agriculture makes up of the GDP, about 7 percent.  This capital flight can only damage the developing economy.

            Recently, one mafia group in Russia laundered approximately $4 billion through the Bank of New York.  Semyon Mogilevich, a financial mastermind with a degree in economics, heads the group, and is reportedly worth $100 million[viii].  These large-scale crimes hurt the young Russian economy, a financial system that needs investments and money injected into it, not sent overseas. 

Capital flight, while extremely important, is only one way the mafia has put the Russian economy under its power.  A major component of the mafia’s power over the economy is the “protection” it offers to businesses.  Protection, according to Diego Gambetta, author of The Sicilian Mafia, distinguishes true mafias from other criminal groups[ix].  Protection takes many forms in the Russian mafia; the mafia can protect the business from other mafias, the government, other businesses, or from the mafia itself.  Protection is an important factor in a business’ success, and often without it, the business will go under. 

Protection is vital for businesses in Russia’s new economy for many reasons.  Most importantly, the increased profits the businesses see by using “protection”.  An extremely high tax rate allows the mafias to charge less than the tax rate for protection, while hiding the company’s true profits from the government.  Many Russian businesses declare only a portion of their true profits because of the prohibitive tax rate.  Larissa Piyashava[x], Moscow’s ex-Director of Privatization, put it simply when stating that if the government demands 80 percent of your income, but the mafia demands only 50 percent, the choice is easy.  As described by Peter Fillipov, former economic advisor to Boris Yeltsin, a common scenario in Russia is that the mafia confronts a business owner who declares only a fraction of his output.  The mafia, who has already sent in people posing as workers and has found out the actual output, tells the owner that they will alert authorities of the corrupt practice if the owner does not pay the mafia.  The owner will always choose to pay, because the mafia’s “protection” fee is far less than taxes[xi].   The mafia, through its extensive ties to the government, is able to hide the firm’s real output from the authorities.  The mafia, in this way, takes millions - perhaps billions of dollars each year from the Russian government and economy.  By sidestepping the Russian government, the mafia cripples the Russian agencies that use taxes for public welfare, and therefore the economy.

Protection also affords businesses the luxury of contract enforcement.  In a capitalistic economy where contracts sustain the economy, contract enforcement is an important issue.  The problem with legal contract enforcement in Russia is that it takes a long time and is very costly.  In an economy where 45 percent of the aggregate volume of accounts receivable were delinquent[xii], and where virtually no legal penalty for breach of contract exists, contract enforcement is even more crucial.  Since vertical integration is not very likely for many Russian businesses, the mafia is the most efficient way for businesses to ensure that their contracts will be fulfilled.  When businesses in an economy trust illegal groups more than their own government, a problem exists.  The mafia has such influence over the economy that it has become a judicial system itself.  This overwhelming power supports the claim that the Russian economy is under the sway of the mafia.

A very important and new phenomenon involving the Russian mafia and the developing Russian economy is that of IMF funds being diverted from the government to the mafia.  The International Monetary Fund has, since 1992, given the Russian Federation billions of dollars in loans to help the economy.  These loans are intended to be used by the government to promote the economic development of the country; however, billions of dollars are unaccountable and have disappeared.  This raises the question of where the money has gone.  It has been reported that $53.9 billion of a $54.8 billion loan to Russia in 1998, had been diverted to other banks.[xiii]  This figure shows that 98 percent of the funds did not end up in the right hands.  The funds allegedly went to 18 other banks in Russia[xiv], while the IMF only delivers loans to the Russian government’s account in the New York Federal Reserve Bank.  Making the divergence of the loans even more unsettling is the fact that the CIA and Russia’s Interior Ministry have reported that the mafia controls more than 80 percent of the Russian banking system.[xv]  The sheer fact that the mafia has that much power shows its negative influence on the economy.  If the mafia was able to audaciously divert so much money demonstrates the tremendous power the mafia wields in Russia. 

What does all this mean to the Russian economy?  Most importantly, foreign corporations are discouraged from investing.  The market that many companies would like to invest in because of large population and cheap production costs is not as appetizing as one would think.  Many businesses do not want to operate in Russia because of the government corruption, the need to conspire with the mafia, and the overwhelming presence of criminal organizations.  The developing Russian economy needs foreign investment to get it on its feet, but unless the mafia is curtailed, foreign businesses will not leap at the chance to practice business in Russia. 

The next problem for the economy is that the fear of the mafia has discouraged many entrepreneurs from starting businesses despite the economy’s need for them.  Business people do not want to operate in an economy where there are criminal organizations that are more powerful than the government, where there is no legal recourse for breach of contract, where “protection” is needed just to operate, and where more than half the banks in the country are associated with the mafia.

The newly capitalistic Russian economy has many problems, and policy analysts have been correct in asserting that the economy is under the sway of the mafia.  The mafia controls so much of the economy that one is hard pressed to show that corporations can function without mafia involvement.  The involvement has damaged the economy by channeling billions of dollars out of the economy, bypassing legal procedures, stealing tax revenues needed to sustain an economy, robbing the country of aid, and discouraging foreign investors and domestic businesses from starting up.  The Russian mafia has control, influence, and power over the economy, and unless there is major reform in the government this will continue.  However, in a society where criminal slang is in everyday speech[xvi] and where officials have been corrupted for decades, this seems unlikely.

 

 

             

 

 



[i]  Journal of Economic Issues, “Mafianomics: How did the Mob Enterprises Infiltrate and Dominate the Russian Economy.”  By Mark Tomass.  06/01/1998.  Pg 565 Vol. 32, No. 2

[ii] From Journal of Social, Political & Economic Studies:  “The Mafia Threat to Freedom in Russia.” By Jennifer Kelly      Pg. 121 Vol. 23 no. 2.  7/01/1998

[iii] From testimony by Arnaud de Borchgrave, Director of the Global Organized Crime Project before the House Committee on International Relations as reported by the Journal of Social, Political & Economic Studies:  “The Mafia Threat to Freedom in Russia.” By Jennifer Kelly  Pg. 121 Vol. 23 no. 2.  7/01/1998

[iv] Brookings Review, “Mafiosi and Matrioshki; Organized Crime and Russian Reform.”  By Clifford Gaddy, Jim Leitzel, and Michael Alexeev.  01/01/1995.  Pg. 26 Vol. 13, No. 1

[v] From the Transition Newsletter, Published by the World Bank.  By Louise I. Shelley.  Jan/Feb 1997

[vi] ibid

[vii] World Bank: Russia at a Glance:  http://www.worldbank.org/data/countrydata/aag/rus_aag.pdf

[viii] From interview with Robert I. Friedman, journalist, on CNN Moneyline: Willow Bay. 08/19/1999. 18:30.

[ix] Diego Gambetta: The Sicilian Mafia: The Business of Private Protectionism, Harvard University Press.                               1993

[x] From The Washington Times, “Russia’s Devious Ways of Doing Business”  by Arnold Beichman. 12/20/1998 Pg. A17

[xi] ibid

[xii] Brookings Review, “Mafiosi and Matrioshki; Organized Crime and Russian Reform.”  By Clifford Gaddy, Jim Leitzel, and Michael Alexeev.  01/01/1995.  Pg. 26 Vol. 13, No. 1

[xiii] From Corporate Finance: “Russia- The Economy to Watch”  by Mike Halls.  11/01/1999 Pg. 56

[xiv] From the Transition Newsletter Published by the World Bank:  “Foreign Loans in MonsterLaundering?  The Mafia, Oligarchs and Russia’s Torment”  July/August 1999 from:

     http://www.worldbank.org/html/prddr/trans/julaug99/pgs11-13.htm

[xv] From the Transition Newsletter Published by the World Bank:  “Quotation of the Month: “Criminal Financial Dealings Dramatically Increased in Russia” Russian Editor Reveals Banks-Mafia Connection  November/December 1995 from:      http://www.worldbank.org/html/prddr/trans/n&d95/quote.htm

[xvi] From Europe-Asia Studies: “The Rise in Organized Crime in Russia: its Roots and Social Significance.”  By Tanya Frisby 01/01/1998 Pg. 27 Vol. 50 No 1.