Why blame the Russians?

Edward Luttwak

One explanation for Russia’s catastrophic financial crisis would begin by evoking the Byzantine Empire and its influence on the ancient Russians to demonstrate that their economic culture was always statist, even under the Tsars. That is why they do not know how to run a stable and successful free-market economy, in spite of all the good advice and all the billions of dollars of loans they have received from the West. Another would merely note that ‘Arabian light’, the petroleum that sets the base price of all forms of energy throughout the world, is selling for $10.11 cents a barrel, the lowest it has been since the Great Depression of the Thirties, taking inflation into account. Prices of other commodities exported by Russia are just as low, beginning with gold at $283.15 an ounce. The advice the Russians have received since the fall of Communism has, in any case, often been dubious and always contradictory. As for the billions of dollars, South Korea’s 1997 emergency loan package was more than twice as large as Russia’s earlier this year.

For all its enormous difficulties in converting from Communism to capitalism, the Russian economy had two enviable advantages until very recently: its export earnings greatly exceeded its imports, so that its overall trade balance was in surplus in spite of large interest payments. And the total Russian debt was not large at all: in fact, it was well below the famous limit of 60 per cent of GNP imposed by the Maastricht rules. That is why, despite all the horror stories about the slow pace of privatisation, the seemingly unlimited power of semi-criminal plutocrats, the massive outflow of capital to buy apartments in London and villas on the Côte d’Azur, foreigners, including George Soros, were willing to join local banks in financing the Government by buying its Treasury bills at their monthly auctions. After all, the money was being lent to a borrower who was earning large foreign exchange surpluses every month, and was less indebted than the United States or Japan, not to speak of Italy.

It is not the abrupt twists and turns of Yeltsin’s policies nor even the notorious machinations of the plutocrats that have deprived the Russian economy of both advantages. Chronic deficits in services and a reliance on imported food for city-dwellers (agriculture is fatally retarded by the Duma’s refusal to privatise land) continued while the value of Russian exports steadily declined as a result of the global collapse of commodity prices, beginning with oil and gas. A balance of external payments that had always been in surplus thus started to generate deficits. As for the transformation of a relatively low total debt into an intolerable burden which finally resulted in the freezing of Treasury bill redemptions, it was not the result of mysterious plots or colossal thieving but rather of sound financial choices. Like any other government, the Russian one relies on borrowing to provide a steady flow of funds between periodic tax collections. Naturally wanting to economise as much as possible on the resulting interest payments, the Ministry of Finance issued short-term bills (GKOs), for the most part with a 30-day maturity, because their interest rates were lower, rather than one-year or five-year bonds. That did of course mean that the monthly auctions had to procure huge sums, resulting in a massive refinancing requirement. If you borrow one million lire on a daily basis instead of obtaining a ten-year loan, the total interest you pay might be lower in the end but you have to find a fresh million each day to turn over the debt, instead of having ten years to come up with that same million. As of April this year, 40 billion dollars in rouble-denominated Treasury bills were due for turn-over through the end of 1998.

For several years everything went rather well. The Finance Ministry naturally had to pay much higher interest than its American counterpart – at least 20 per cent as opposed to 5-6 per cent, let alone Japan’s 1 per cent – but plenty of money was coming in, and by the end of 1997 GKOs attracted so much interest world-wide that foreigners (and Russians operating through their foreign bank accounts) were holding roughly one half of Russia’s short-term debt. That showed confidence in the Government and its financial management, which in turn encouraged foreign companies to make direct investments bringing much-needed capital and even more badly needed new technology and business methods into the Russian economy.

What the Russians did not anticipate was the East Asian financial crisis, and its impact on their own public finance. Soviet schools had always taught that capitalism is inherently unstable, its history a sequence of frenzied booms followed by hysterical crashes that disrupt economies causing much suffering and waste. Having discovered that Communism was wrong about so much, many Russians, including the key officials of the Ministry of Finance and the Central Bank, evidently became convinced that it was wrong about everything. They saw free-market capitalism as a secure highway to prosperity rather than a turbulent ocean which must always be navigated with great prudence. They could have acted promptly to diminish the Treasury’s reliance on short-term, rouble-denominated debt as soon as the Thai collapse inaugurated the East Asian crisis. The rouble still held steady against the dollar, and there were no great obstacles to the issue of dollar-denominated longer-term debt to replace at least a portion of the monthly quota of expired GKOs. And to owe dollars instead of roubles was no greater burden or risk, given that the rouble was already fully convertible. Instead, as I know at first hand, the highest Russian officials did nothing because they were convinced a) that the crisis would be localised; b) that even if it spread to the rest of South-East Asia, the United States would intervene to ensure that it did not contaminate the more solid economies of South Korea, Hong Kong or China; c) that even if the crisis engulfed all of East Asia, its effect would be quite small because few Russian exports other than timber go to those markets. If the Governments of Western Europe are still today allowing their central bankers to fight the dead dragon of inflation, while ignoring the global deflation that is ruining commodity exporters everywhere regardless of their specific markets, the Russians must be allowed their mistake.

Not only did Russian officials view capitalism itself with excessive respect, they also had much too high an opinion of its institutions. They saw an all-powerful US Treasury, a highly expert IMF, majestic banks with centennial histories and huge reserves, and ultra-sophisticated investment funds led by financial wizards. What they never seem to have realised is that much of the monthly GKO turnover was in the hands of very new mutual funds hurriedly set up in the Nineties to exploit the foreign-investment boom. These young and inexperienced traders had only the vaguest ideas about the Russian economy – or anything else which did not appear on their computer screens – and one of the many things they did not understand was how small Russia’s total debt was as a percentage of GNP. Even the official percentage was a gross overstatement because it measured the debt against GNP statistics that did not include the huge black economy, which even slightly more effective tax collection could tap.

What happened was that many ‘emerging markets’ funds, which lost money twice over in East Asia as both currencies and stock and bond prices collapsed, became frightened that the same thing would happen to their rouble-denominated GKOs. They did not stop to calculate export dependence, the true debt burden or anything at all: they simply sold off their GKOs at a discount, or at best waited a few days to redeem them. There was no question of buying a fresh lot: they wanted to get their money out. The bolder ‘hedge funds’ which replaced them naturally wished to be paid well for the added risk. The result was that GKO interest rates first rose steadily to 40 per cent or more, and then, when the East Asian crisis became worse, they exploded above 100 per cent, at times reaching 150 per cent, multiplying the burden of interest payments on the Russian Treasury.

The fall in oil and other commodity prices turned a disproportionate, and now very costly, reliance on short-term debt into a financial timebomb. Foreign currency reserves kept falling, going well below the level of the monthly turnover in GKOs held by foreign investors. Everything was set for a foreign-currency insolvency crisis. All that was needed was for the hedge funds to become sufficiently frightened to give up their GKOs. And they had plenty of reason to worry as Japan continued to sink and oil prices kept going down.

That is why the July rescue package co-ordinated by the US Treasury, acting through the IMF, was so unpersuasive; and contrary to the impression given in the press, it was not the reluctance of the Duma to approve the usual IMF preconditions that scared away foreign investors – in the end, the dominant Neo-Communist bloc accepted almost all of them – but rather falling oil prices and the worsening balance of payments.

Once there was talk of a ‘moderate’ (15-20 per cent) devaluation, panic drove the GKO interest rate up to 200 per cent per annum – which is not a rational response to the threat of a moderate devaluation. It showed that investors did not want to hold Russian debt at all. The main Russian reason not to devalue – i.e. the resulting loss of investor confidence – thus ceased to be valid, because investors had already lost all confidence in Moscow’s public finance. That being so, a hard-pressed government running out of foreign exchange, which could not in any case safeguard its long-term credibility, also had to stop redeeming GKOs and promise longer-term bonds instead. That avoided an outright confiscation but it was still a default in all but name.

No other outcome was possible once fresh money stopped arriving – unless of course the United States, Western Europe and Japan were to intervene once again, with or without the fig-leaf of the IMF. Unlike the Russians themselves, they had excellent reasons to do everything necessary to stop a devaluation which could only accelerate the cascade of competitive devaluations around the world, starting with the former Communist economies of Eastern Europe and Central Asia which still export a lot to Russia.

The immediate threat, still very much with us, was increased pressure on key currencies already under attack, such as Brazil’s and China’s, which can pull down other regional currencies with them. Devaluations in turn wreck economies that might still be doing well overall but which have foreign debts on which they have to pay interest and repay principal in hard currency. As of now, debtor countries as economically significant as Argentina, Brazil and Mexico, all the wounded tigers of East Asia, as well as the oil-exporting countries from Russia and Venezuela to Oman must earn their foreign currency under the twin handicaps of falling commodity prices, and of the IMF requirement that they export more and import less – very hard to do when so many other countries are also under orders to export more and import less.

The crisis itself and the IMF’s cure – almost as destructive – can have only one result: a downward spiral in world trade that is already impoverishing some 500 million highly productive people who were on their way to prosperity; another 900 million could join them quite soon. Naturally, these people have stopped buying American, European and Japanese exports. Brazilian soya bean farmers are buying fewer shirts as vegetable oil prices fall; shirt-manufacturers are selling fewer shirts and firing employees who then buy less vegetable oil; textile-machinery manufacturers are selling fewer machines; and so it goes on, bouncing from sector to sector and around the world, hitting even the stock markets of New York and Milan, where no soya beans are grown. Along the way, real estate prices also fall, weakening banks whose construction and mortgage repayments start defaulting.

There is nothing special about all this – that is how capitalism should work, liquidating speculative and investment excesses in order to be able to resume its growth. But the liquidation is turning out to be far more destructive than necessary, because of an essentially political failure to supply credit. Western governments which in their own interest can and should help troubled economies are instead doing little or nothing. It is not a good idea to lend yet more money to chronic wasters and thieves à la Zaire-Congo, or to the East Asian economies that have not yet fully liquidated years of speculative excess. But countries, including Russia, that had a favourable trade balance until commodity prices went into a downward cycle, eminently deserve loans to tide them over until the cycle turns again – for if they remain unassisted it will not turn at all. The last time such a thing happened, in the Thirties, it took a world war and its infinite demand for everything to lift depressed commodity prices.

That present reality – it is no longer just a danger – is a painful symptom of a broader economic disease familiar from the past: devaluations that force other countries to devalue in order to remain competitive, leading to a fall in world trade as everyone imports less, leading to a fall in world production, leading to a fall in world employment and incomes, leading to a further fall in world demand, which leads to a further fall in world trade …

The US Treasury has been aware of the causes and consequences of the disease for almost two years. But facing Congressmen obsessed by their local concerns, the Treasury cannot act on a large scale without strong Presidential leadership. And the US President is incapacitated. There is nothing to stop him launching Cruise missiles, but he is not at liberty to authorise a strike on the Republican majority in the two Houses of Congress: he must instead persuade them, and as of now he cannot even persuade his fellow Democrats.

The European Union and the major countries of Western Europe, for all their vast pretensions, remain passive as the crisis spreads, fixated on their own Euro-plan of strict monetary discipline, which forbids any action to help Russia or any other country. Even more than the United States, which worships at the feet of Alan Greenspan, the Europeans obey their central bankers, who oppose any increase in public expenditure for any reason at any time. They are still proudly dedicated to fighting inflation – when there is no inflationary pressure at all. A Thirties scenario of global economic depression leading to massive impoverishment has ceased to be an impossibility. It is high time to recognise that the global economy is too important to be left to central bankers whose monetarist fanaticism is far more dangerous than the fanaticism of Osama bin Ladin.

To intervene now, with what it would take to repair the broken pieces of Russia’s public finance – much less than $40 billion – would do a great deal to stop the contagion before it reaches deeper into Europe, before it further aggravates the worldwide disease of deflation. If nothing is done by the United States, Western Europe and Japan – which is highly likely considering the intense provincialism of their current leadership – what will the Russians do?

We are being told that we should deplore the return of Viktor Chernomyrdin to power, because he is not a free-market enthusiast like Anatoly Chubais & Co. We are further told that he has already embarked on the wrong path by sitting down to negotiate with both the top plutocrats and the Neo-Communists, who of course oppose economic liberalisation. Somewhere along the way, the chorus of Western critics seem to have forgotten that the Russian Federation is now a democracy, that the Neo-Communists form the largest single bloc in the Duma, and that Chernomyrdin’s bitter contest for parliamentary approval was not a matter of negotiating with the editorial writers of the Wall Street Journal and the Economist.

It was with Chernomyrdin running the Government that Yeltsin achieved his one great economic success, the taming of hyperinflation. If the Russian Government cannot now quickly reduce its budget deficit, a return to hyperinflation is quite likely. Reducing the deficit can only be done by a) cutting spending, which requires the approval of the Neo-Communists in the Duma, and b) raising direct taxes, which requires the co-operation of the plutocrats, the only ones who have the money to pay a lot more taxes. Chernomyrdin is therefore doing exactly the right thing by seeking the support of both plutocrats and Neo-Communists.

It is Russia’s misfortune that it joined the global economy, not during the postwar decades of tightly controlled capitalism that came to an end in the Eighties, but only now, in the anarchic disorder of today’s ‘turbo-capitalism’ – a world of dynamic creativity, rapid innovation, increasing inequality and colossal capital markets that nobody controls.

If a partial retreat from financial (as opposed to industrial or commercial) liberalisation is the one thing that will keep the Russian Federation from collapsing into outright chaos, this is not to say that the Russians must condemn themselves to backwardness and isolation. For the present turbo-capitalism cannot long endure either: indeed, it may already be coming to an end. Even in the free-market mecca of Hong Kong the Government is spending its hard-currency reserves to keep up both the Hong Kong dollar and the stock market. The Russians have no such reserves, but they, too, have an already impoverished real economy of jobs and salaries to protect from catastrophic financial upheavals.