(FORTUNE Magazine) – Stand in the middle of Ulan Bator's main square, and Mongolia's strange history unfolds around you. To the west lie the grasslands, whence Genghis Khan charged forth to conquer half the world. At the southeast corner, a statue of Lenin recalls Mongolia's seven decades as the Soviet Union's most dependent satellite. And the square itself is where Mongolians mourned the death of Sanjaasuregiin Zorig, a hero of the 1990 democratic revolution, who was axed to death in early October.

But it is on the southwest side of the square where this story begins. There stands the Mongolian stock exchange, a monument to the Harvard graduates who a few years back descended on Ulan Bator to teach the locals capitalism. Inspired by Harvard economist Jeffrey Sachs, these young technocrats tried to help Mongolia turn itself into a free economy.

To a certain degree, they succeeded. Today all across the Mongolian steppes, herders trade shares in local companies. In Ulan Bator, the acting Prime Minister's senior economic adviser dreams of erecting a statue of Milton Friedman on a hill overlooking the capital. Mongolians, it seems, are determined to test--in the most extreme conditions--the American theory that capitalism and democracy are universally exportable.

For the most part, however, the results of this experiment have been disappointing. Yes, there has been progress. Inflation has slowed, and small pockets of entrepreneurial activity can be found. But when Mongolia's reformers decided to put the country under economic shock treatment, they expected a quick route to prosperity. The reality has been anything but. Capitalism has not come fast or easy for a country weighed down for decades by the Soviet model. Today the Mongolian economy is marked by unemployment, bad debts, and a lack of foreign investment.

Survey the terrain and it's easy to imagine why American-style capitalism is having such a hard time taking root. Mongolia is a vast, landlocked expanse wedged between China and Russia. Half the size of India, it has just 2.4 million people. Until 1990 this residue of Genghis Khan's great empire was the most isolated and backward of all the Soviet bloc countries. According to World Bank estimates, in the late 1980s almost a third of Mongolia's GDP came in the form of Soviet subsidies. Meanwhile, 90% of the country's negligible foreign trade--with copper and cashmere the only exports of note--was funneled through the U.S.S.R. and Eastern Europe.

Mongolia is acutely underdeveloped. Dirt tracks count as interstate highways; livestock outnumber humans by 12 to one; at least a third of all Mongolians live in tents on the grasslands and Gobi desert. True, Mongolia boasts an official adult literacy rate of 96%, but that is a rare bright spot. Last year per capita GNP was just $369, and a quarter of the population subsists below a meager official poverty line of $12 per month.

This country's odd love affair with Western capitalism is reason enough for charting Mongolia's progress since 1990. But the story also has a more immediate resonance, as the rest of the region rethinks the "Asian" model of development. "Asian values"--meaning the once vaunted model of authoritarian capitalism--"have not gone down well here," observes Alphonse La Porta, the U.S. ambassador in Ulan Bator. By contrast, he suggests, American values have gone down extremely well. That assessment is not entirely true, but is true enough to have prompted a visit last April by Secretary of State Madeleine Albright, who came to bless Asia's most libertarian nation. And the U.S. is interested enough in Mongolia's experiment in building democratic capitalism on the steppes to have made the embassy a command center for a host of aid programs.

How did Mongolia's romance with America blossom? Not long after the collapse of the Berlin Wall, Mongolia's one-party communist state also began to totter. It was at this point that the Asia Foundation, a nonprofit American cultural organization that gets congressional funding, received a letter from Mongolia's U.N. mission requesting help in building democracy. In March 1990, following peaceful pro-democracy protests in Ulan Bator, Mongolia's ruling politburo resigned, making way for the country's first free elections. In the fall of that year Sheldon R. Severinghaus, the Asia Foundation's northeast Asia hand, arrived in Ulan Bator for a reconnaissance trip.

What he saw was a straggling city of 650,000 people living in grim, stack-a-prole tenement blocks or traditional felt tents (gers) on the northern perimeter. The only "Western" restaurant was a Czech joint that dispensed greasy Eastern European fare, washed down by cheap Mongolian vodka. Three antiquated Russian power stations wheezed hot water around the city--most inhabitants' only defense against the brutal winter.

Landing in this blighted landscape, Severinghaus got a warm welcome, even though the communist Mongolian People's Revolutionary Party (MPRP) was still in power, having won the election in June. In a further twist, the MPRP had then invited the democratic opposition to take charge of economic and social policy. Yet if the political scene was confused, what united all Mongolians was an ardent desire to embrace the West. Partly it was a question of geopolitics: With the departure of the Soviets, Mongolians feared renewed domination by China (which had controlled the country until 1911). Beyond politics, however, Mongolians seemed drawn to liberal ideals as a reaction against their own isolation. Observes Ganbold, a leader of the democratic movement: "After 70 years of communism, we became more Western-minded than any other Asian country."

So it was natural that Mongolian officials should want to draft a new, U.S.-model constitution. Severinghaus recruited American legal experts to offer advice, and when the constitution was ratified in February 1992, there were obvious American flourishes. Mongolians, the preamble declared, cherished "human rights and freedoms" and aspired to "the supreme objective of building a humane and democratic civil society."

They also aspired to construct one of the world's most open economies. Enter Ganbold, who in 1990--at the age of 33--had accepted the economics portfolio as Deputy Prime Minister. Undaunted by his limited exposure to market economics, this Moscow State University graduate unleashed a program that, he recalls proudly, was "exactly according to Milton Friedman's ideology." Privatization, price liberalization, and a free currency were the order of the day.

Ganbold wasn't the only shock therapist in the treatment room. Zolzhargal, then 25, was the son of a trade minister. Zolo, as he is known, had first imbibed market theory in relatively liberal communist Hungary. In 1989 he had visited America on a U.N. scholarship, where he had read a paper on Soviet economic reform by Jeffrey Sachs. That was enough to convince him that Mongolia needed a stock market. In the fall of 1990, Zolo, acting as an unofficial adviser, devised a plan that was instantly adopted by the government. Pink vouchers, bearing a picture of Genghis Khan, would be issued to all Mongolians, enabling them to bid for livestock (collectivized by the communists), smaller state-owned factories, and government shops. Later, blue vouchers could be used to purchase the rest of Mongolia's state portfolio. Simple, really.

Today, Zolo remains a free-market messianist. "Oh, c'mon, c'mon," he protests in thickly accented English, when FORTUNE enquires about poverty. "As an economist, I never believe that Mongolia is in deep poverty trouble." Since April, Zolo has been advising the Prime Minister, and he sees only good news on the horizon. Pulling a sheaf of papers from his desk, he explains how the government is hitting the IMF's targets, and boasts that these figures are "scaring" the MPRP, which is now in opposition. Why? "Because we're too good," retorts Zolo, lighting another cigarette.

In 1990, Zolo had read Sachs, but Sachs had certainly never heard of Zolo. They met at the Davos economic summit in 1991. Recalls Sachs: "He said, 'Your paper on market reform has made a big hit in Ulan Bator. Can you come?' Well, you can't pass up a line like that, so of course I came." What Sachs saw, however, convinced him that building capitalism in Mongolia would take time. "I've told them jocularly that their competitive advantage was very strong in 1200, when grass was the key to support a large cavalry. But with the coming of the musket in the 14th century, their competitive advantage really ended."

Consider, in this context, how Mongolia's landlocked position, sparse population, and weak industrial base have undermined attempts to exploit the country's natural resources. Mongolia is one of the world's leading raw-cashmere suppliers, producing about 2,500 tons in 1997 from a herd of 10.3 million goats. But it lacks processing technology to finish the product. Mongolia is also rich in minerals, including gold and uranium. But its remoteness has deterred the mining multinationals; only copper has proved a major earner, accounting for 60% of Mongolia's export revenues in 1997. Tourism is potentially Mongolia's best asset; it had 65,000 overseas visitors last year. But there's little room for more, pending a drastic upgrade of Mongolia's transport and hotel network. In sum, there's not much in Mongolia's portfolio to draw outside capital, which has therefore stayed away.

Since 1990, Mongolia has attracted just $200 million in foreign investment and parceled out between 840 jointly owned or wholly owned ventures. China (33% of projects) and Russia (20%) remain the dominant investors, a troubling pattern for a country determined to keep these overbearing neighbors at bay.

Back in 1991, Sachs identified a further handicap. Despite the reformers' enthusiasm for free-market theory, seven decades of communism had left the country ill-equipped for the practice of capitalism. So that summer, Sachs dispatched six of his top graduate students to Ulan Bator to teach Mongolians the basics of how to run a market economy. "It was a special time," says Enkhbayer, Zolo's deputy on the stock exchange project. "In the morning the Americans taught the stock exchange staff, and in the afternoon we taught another 400 students."

So how did the class perform? Not so well in the case of Zolo's elder brother, Zhargalsaikhan, governor of the central bank. Shortly after the Harvard classes finished, it emerged that he and a clique of young bankers had lost 80% of Mongolia's foreign exchange reserves (about $82 million) speculating on international money markets.

It wasn't mistakes, however, that short-circuited Mongolia's first round of shock therapy, but Moscow's decision at the end of 1990 to cut all subsidies. In 1991, according to the IMF, GDP fell 9.2%, and only $155 million in international aid prevented the economy from total collapse. Under pressure, Mongolia's reformers disintegrated into a bickering rabble. Eight democratic parties fought the election in June 1992, allowing the former communists to win 71 out of 76 seats. Thus began four years of undiluted MPRP rule. Reform all but stopped.

By the mid-1990s Mongolia was in terrible shape. Outside Ulan Bator's main department store, women sold cigarettes from the packet. Street children were everywhere, begging by day and sleeping by night in the underground sewers. Men staggered around town drunk on vodka. Across the frozen grasslands, thousands of urban refugees depended on trade and barter to survive.

In Ulan Bator the reformers were lying low. At the newly opened stock exchange, Zolo cursed the government's ineptitude and preferred to discuss his latest project: Mongolia's first professional basketball league. Ganbold, still an MP, was a political bystander. In 1995 the IMF would temporarily suspend its Mongolia program.

Yet these were not wasted years for a stream of latter-day American missionaries, including scores of Christian evangelists. And at the Asia Foundation--appropriately installed in a log cabin on Ulan Bator's Freedom Square--Severinghaus was busy building democracy. "We went to the grassroots for the first time, supporting people who wanted to form" civic organizations, he explains. Many of these were women's groups, including the memorably named Liberal Women's Brainpool.

Then there was the International Republican Institute (IRI), affiliated with the U.S. Republican Party. Mongolia first registered on the IRI's screen in 1991, after a visit to Ulan Bator by then-Secretary of State James Baker. "In the big picture, Mongolia wasn't all that important to the U.S.," he recalls. "But symbolically it was very important [as] the first Asian country...to embrace democracy and free markets."

At Baker's urging, the IRI moved into Ulan Bator. It began offering all Mongolia's parties training seminars. The MPRP dropped out, however, and by default the IRI focused its expertise on the democratic opposition. First, the reformers were persuaded to fight the next election as a coalition. Next, they were acquainted with a proven vote winner: Newt Gingrich's Contract With America. Enter the Contract With Mongolia, which promised a free-market revolution. Says Jeff Crouse, the IRI's Asia director: "Today, if you visit a ger a good 500 miles from Ulan Bator, you'll find contracts hanging on the wall." Well, maybe FORTUNE picked the wrong tents; none of the nomads we visited had ever possessed a copy.

It's indisputable, though, that the IRI galvanized the coalition. In June 1996 the reformers returned to power with 50 parliamentary seats. James Baker, back in Mongolia as an election observer, was astounded by the 93% turnout. "We in the West could learn a lot from Mongolians," he says. "These people would ride horseback 25 kilometers to cast a vote."

No other Asian country enjoys more political freedom today than Mongolia. True, there's corruption and cronyism, plus communist relics still lodged in the bureaucracy. But Mongolian democracy outscores the rest of the region on virtually every count. That's not all. Since 1996 no other Asian country has shown greater commitment to open markets. Mongolia's misfortune is to have received so little reward for its efforts.

That wasn't the intended outcome when the reformers launched Shock Therapy II in the summer of 1996. Pumping the voltage was Enkhsaikhan, then 41, who was appointed Prime Minister. His feet were barely under the desk before energy prices were freed, causing an overnight 60% rise in fuel costs. Within months, all import tariffs were abolished, except on cigarettes, alcohol, and cars. Meanwhile, 900 state-controlled companies, equivalent to 60% of public assets, were slated for privatization by 2000, including Mongolia's big three: the Erdenet copper mine, worth about 20% of national GDP; the Gobi cashmere factory, with a 20% global market share; and the state airline. Not one of the trio has yet been tendered, although the selloff is promised within two years.

A genial, laid-back figure who has run an investment group since his ouster as Prime Minister in April, Enkhsaikhan has no regrets. He argues that his countrymen can withstand the suffering his shock therapy caused--notably the sudden increase in fuel prices, which helped double inflation to 58% between June and December 1996. "Pain is easily tolerable for a short time," he says laconically; in the long term, he believes, Mongolia will be better off for the treatment.

And indeed, some of Mongolia's numbers have been moving in the right direction. Inflation is now below 15%, compared with a peak of 183% in 1993. Foreign reserves stand at about $75 million. In Ulan Bator, the first half of 1998 even saw a modest consumer spree.

Trouble is, Asia's turmoil has now hit Mongolia with a vengeance. World copper prices fell 23% during the first four months of 1998, wrecking the government's budget plans. Japan and the Asian Development Bank are both reducing their aid. The banks are tottering under a pile of unrecoverable debt--the result of bad loans, backdoor deals, and 70 years of financial mismanagement. Around 200,000 of Mongolia's 900,000-strong work force are officially jobless.

The moral of the story, brought home by the regional crisis, is that building capitalism is a long, hard struggle. That isn't the view of Mongolia's shock therapists, who still cling to the assumption that free markets yield almost immediate payoffs--even though seven years have passed since the first shocks. Insists Zolo: "The living situation improves day by day. I'm not talking about years."

Sachs, the original shock-therapy guru, begs to differ. He and his team propose three measures, all of them long term, to help Mongolia prosper: more roads, improved livestock breeding, and investment in information technology.

There's no better illustration of Sachs' analysis than Moron, an unhappily named provincial capital of 25,000 about 500 miles northwest of Ulan Bator. Planted on the grasslands to fulfill a doomed Soviet-era industrial plan, Moron (which means "big river") is a jolting 22-hour jeep ride by dirt track from the capital. By the end of the journey you're bound to agree that Mongolia badly needs asphalt. It's a forlorn settlement of squat wooden dwellings, punctuated by the occasional tenement block. When the rain sweeps down the hills, you wonder what the locals do for fun. Not much, because electricity is available only six hours a day. The best action FORTUNE could find was a video shack, running Russian gangster videos off a diesel generator. The moviegoers have nothing better to do. None of Moron's handful of factories are working at full capacity. At the provincial government headquarters, senior official Altangerel says there are about 2,000 people on the jobless register, and underemployment is rife.

As the rain drives against his office window, Altangerel catalogs Moron's entirely typical post-communist collapse: When Soviet subsidies stopped, so did investment from Ulan Bator. "Two years ago I was sacked by the flour factory," says Tulgaa, an angry 27-year-old man in a crowd of about 30 people queuing for welfare handouts. "It's impossible to find work."

Tulgaa curses the government, and Mongolia seems a long way from Harvard. Next door in the post office, though, is true grist for Sachs' policy mill. At present it can take 30 minutes to call Ulan Bator, and sometimes there's even a charge for electricity. But soon, according to Altangerel, Moron will possess a satellite dish, installed with American aid. By the end of 1999, he says, locals will be making IDD calls, sending faxes, and hooking up to the Internet.

Which leaves the livestock: 31 million, including 14.1 million sheep and 10.3 million goats, the largest herd in Mongolian history. For Ganbold and other urban reformers, the animal numbers confirm that privatization works, because more livestock equals greater wealth. In the grasslands around Moron, the herders don't always see it that way. Take Dashumberel and his wife, Tsetsgee, who until 1993 held state jobs in a village cooperative. The cooperative was dissolved. Today they live with their five children in a tent about 30 miles north of Moron, tending a herd of 130 animals. When the livestock exhaust the pasture, they strike camp and move to the next site.

Dashumberel's herd could certainly be improved by scientific breeding, if he could raise his sights from the basic challenge of survival. Inside his ger, he offers FORTUNE a welcoming bowl of fermented mare's milk before outlining his family's plight. "Compared with the socialist time, life is worse," he says. "Before we had a regular income. Now we have to depend on the animals." And yet both Dashumberel and Tsetsgee voted for the democrats in 1996. "We think democracy is important for Mongolia," explains Tsetsgee simply.

This is not a story with a happy ending. During the past seven months Mongolia has descended into factional turmoil that threatens to wreck the fragile economic and political achievements of the past eight years. In April, Enkhsaikhan and his cabinet were ousted by fellow democrats in a parliamentary coup. His successor, Elbegdorj, vowed to continue the reform program, but by June the new government was engulfed in a bank merger scandal. In July, Elbegdorj lost a parliamentary vote of confidence, ushering in Mongolia's darkest political hour since 1990.

Six times Ganbold has been proposed as Elbegdorj's successor, only to be rejected by Mongolia's President, an MPRP stalwart. Other candidates were also rejected, until in October the coalition advanced an illustrious name: Zorig, a 36-year-old minister in the Elbegdorj cabinet and, more important, a hero of the original pro-democracy movement. Zorig's candidacy was never put to a vote. On Oct. 2, two masked assailants burst into his home and tied up his wife, and when he returned, they axed him to death.

As FORTUNE went to print, the killers were still at large; their motive is anyone's guess. Says Severinghaus: "It's a black event for Mongolian politics, but I'm not sure it's a black event for Mongolian democracy." Like thousands of ordinary Mongolians--who marked Zorig's death with a national day of mourning--he hopes the murder will bring the country's feuding politicians to their senses. But that hasn't happened yet. Ganbold was proposed yet again in mid-October to serve as Prime Minister, but on Oct. 15 the President once more refused to approve his appointment.

At such a time the dreams of one Mongolian economist seem almost beside the point. "Why not? Why not? I still believe it," Zolo declares emphatically, when asked about the Milton Friedman statue. Zolo has even picked the spot. For future visitors to this strange, sad country, it's next to the Soviet military memorial, on a hill overlooking the capital.