These comments were published in Rossiyskaya Gazeta

Recently journalists have asked me whether it would be better to deal with the crisis first and then focus on modernization, or even whether it would be better to refrain from overextending our resources all together. It is, of course, logical to tackle issues step by step.

The Ministry of Economic Development expects the economy to grow by 3% in 2010. The implication is therefore that we can start the mass modernization of the economy in 2011-2012. Unfortunately, we do not have time for such formalities – either practically or politically.

While observing the audience at the Kremlin’s Georgievsky Hall during the presidential address, I noticed many skeptical expressions. It seemed like deputies, members of various parties and local authorities immediately began calculating the price of modernization. It is a known fact that there is no idle money lying around. With only a couple of years left until the presidential elections, the State Duma is unlikely to have extra money to pump into the budget. Nobody will want to make cuts to social services, and because modernization is perceived as being risky the right moment will be missed. A range of political issues will also emerge. For example, it is still unclear which parties will team up to take this forward, which means that it is safer to forget about modernization until after the “elections season.” At present, although the window of opportunity has not been thrown open, there is a gap large enough for us to squeeze through. And it would be foolish not to take the chance.

Modernization – this is not just a call to modernize our society, which retains vestiges of the last century, but also a guarantee that our real economic position will be preserved in the near future. The president set this very large-scale modernization as a goal in his speech at the United Russia congress. As time passes, developed countries are starting to talk about saving energy, switching to a “green economy,” reducing metal consumption and increasing labor efficiency. The U.S. has invested $20 billion to develop a clean energy program. Germany has launched projects worth trillions of euros, one of which seeks to transfer solar energy from Sakhara to the Federal Republic of Germany. The world is reducing (or at least is trying to reduce) consumption of oil, gas, metals and fertilizers. But these represent Russia’s core exports and are a key source of our budget revenue, and we will face changes as a result of these reductions. Moves toward labor efficiency will undermine our key advantage – small salaries. All of this reduces our potential to mobilize our resources, which is in turn compelling us act here and now.

What makes it difficult to modernize an economy that has not yet exited the crisis? Neither the private sector nor the state are capable of stimulating the breakthrough industries and large-scale projects that pave the way for progress. Only tax and custom duty reductions can boost investment in these sectors. And although there is another way out – direct financial support from the state – any financial expert knows that when there is a budget deficit, funding such investment programs will only increase inflation. The resulting 11%-12% inflation rate would make us unable to cope with the crisis. Economists believe that a 5% inflation rate is essentially the maximum rate for stable economic growth. Above that we cannot ensure cheap credit, growth in the real sector and everything that involves.

Contradictions of this kind raise a vital question: where do we get the money for modernization? This question is both theoretical and practical. It will take more than one column in Rossiiskaya Gazeta to answer this question. Theorists and practitioners will likely get into many arguments and will make many suggestions, but not a single economist is capable of providing us with a simple answer. No one can dispute the need to improve the investment climate because the country must attract foreign private investment and sovereign wealth funds. Although the state has little to offer in terms of financial support, we must direct these humble resources toward breakthrough industries. We should again consider a taxation system to ensure that foreign private funds are invested in pharmaceuticals, communication and aerospace - the country should offer significant tax incentives for these sectors. However, starting next year we are replacing the unified social tax with social transfers, which will translate to an 8% increase in costs for businesses operating in these industries. This increase is quite significant. The breakthrough industries specified by the president report higher labor costs compared to other sectors. For example, labor costs in the software development industry exceed 80%. As I have already mentioned, an 8% increase in social payouts will force them to curb their activities, or, at best, will prompt them to transfer specialists to neighboring countries with a much lower tax burden, such as Belarus or Ukraine. These specialists will then try to work remotely from abroad. This option is doable but too complicated. As you see, it is hardly a large-scale move toward modernization.

This is only one example of how to encourage breakthrough industries. Depreciation charges are another tool the state can utilize, and they should be more flexible. An incentive can be offered in the form of a lower interest rate, but this is quite complicated since our financial system is still coping with the crisis. We could turn to large foreign financial institutions for assistance, but they have not yet recovered from the storm either.

I do not want to sound pessimistic. Political will means a lot. If the president and the government firmly exercise that will, it will be possible to resolve these complex issues at least for the breakthrough industries. However, in order to create the appropriate environment for this political will to make a difference we must overhaul management structures – those who have long impeded modernization need to be replaced. This is particularly important for sectors that are constantly criticized by both business and society. Here I refer specifically to the administrative costs associated with extremely negative pressure on businesses from regulatory and law enforcement agencies. It is also vital that society change its attitude toward entrepreneurs and property rights.

What I mean is that every time you plan to launch economic reform in Russia, you end up revising a whole system of moral, cultural and social principles and drivers along with society in general. Thus, at this stage we must leave the issue on the table even though there is no obvious solution. At the same time, we must proceed with an in-depth analysis of the current situation in coordination with the entire government and expert community so that we can find a way out of this complicated situation.

I’d like to add one more thing. Vertical modernization - that is a breakthrough in specific industries - is, of course, hard to achieve under present conditions. It is connected to the search for funds, taxes, and budget expenses. However, horizontal modernization, which requires eliminating administrative barriers and improving conditions for business development, does not require any extra investment. This can begin tomorrow.