Since the implosion of the Soviet Union and its deconstruction literally brick-by-brick, the Russian Federation has had a rough start evolving into a “free market” economic model.  The Russian Federation is likely the second-most talked about economic model, next to “Socialism with Chinese Characteristics”, as the People's Republic of China vaguely describes their own methodology of economic development.  The jubilation of the Russian people at being able to freely traffic in manufactured goods after such a long period of stagnation quickly turned into a simulacrum of soviet life within two years, hallmarked by video recordings and photography of Russian peasants, freed from the yoke of Soviet serfdom only to come face to face, even if subconsciously, of what Marx pointedly called dialectical materialism, specifically the idea that while the names and ideologies change, the economic characteristics of your position in life compared to the bourgeoisie stays the same.  

 The system that emerged in the chaotic years following Yeltsin's peaceful revolution definitely had elements in it that could classify as something Communists tell their children to scare them into being good little party members.  Former party officials and other Illuminati of Soviet society bought up formerly state-owned equipment and infrastructure at bargain basement prices and picked up in a more efficient manner than their predecessors left off.   Perhaps because of a distaste for all things formerly Communist, the people of Russia don't call them the “Bourgeoisie” as a Marxist might, but rather oligarchs. 

 
One of the institutions that was transformed by the leap from Marxist-Leninism to Liberal Democracy was the financial sector, specifically the banking institutions and the central bank of Russia which like other central banks of other nations has the responsibility of setting monetary, but not fiscal policy.  Originally the central bank of Russia was GOSBANK ( Госбанк, Государственный банк СССР, Gosudarstvenny bank SSSR), and was replaced after the collapse of the Soviet Union with the Central Bank of Russia.1  What these two institutions had in common was their authoritative mandate to uphold the stability of the Ruble for the state, what economists mainly refer to as “monetary policy”, as distinguished from fiscal policy, which is the question of budgeting for government institutions and programs. 

The purpose of this paper is to assess the multiple financial crisis' that have occurred in the brief history of the Russian Federation and examine a sampling of the theories and models used to explain these financial hiccups.   Alongside this examination, an independent hypothesis will be evaluated with two main points:  One, that the monetarist economic model accurately explains fluctuations in the value of the ruble over the past 18 years, and two that oil and natural gas production in the Russian Federation serves as a price anchor for the Russian Ruble.  If this hypothesis has some correlative value to it, it makes an effective lens into examining Russian energy policy and monopolization of energy pipelines in Eastern Europe through the context of economic necessity.

The predecessor of the Central Bank of Russia, GOSBANK, was faced with a very severe issue at the outset which crippled its ability to set monetary policy.  Aside from its total control by the Communist Party and loaning out money to pet projects of prominent political luminaires, their main task of monetary managerial policy was hamstrung by an essential contradiction between Marxist-Leninism and monetary policy.  Ludwig Von Mises assessed this critical contradiction in his book Socialism: An Economical and Sociological Analysis, correctly pointing out that using the Ruble as an
exchange unit was a compromise with reality to the detriment of socialism.  In a system where the labor-hour is the ultimate creator of value, and the expressed desire of the political elite is to create a system where money exchange is considered anachronistic and backwards, any monetary authority is operating under, at best, very constricted circumstances.2

 This sets the stage for the earliest signs of trouble in the former Soviet republic starting in 1993, in the first couple of years of “free-fall” from the Soviet apparatus.  In 1992, the Russian Ruble experienced inflation of over 2,000 percent, followed by successive years of 800 percent inflation3.  In his book, Willett and his colleagues assert that the reason for the inflation of the ruble in the 1992-1994 period was because the nascent Russian Federation government was over-reliant on the method of taxation of seigniorage.  Seigniorage is the financial revenue gained when a government institution pockets the difference between the cost to print or coin money, and the declared value of the bills and coinage. 4  For instance, if the U.S. Mint produces a quarter for 10 cents and circulates it to the public, it has technically “gained” 15 cents by releasing that artificial value to a purchasing public without any additional cost to the government of the United States.  This is a common method of revenue generation in upstart republics and it is not unreasonable to assume that overreliance on seigniorage could be the causation of the Russian Federation’s monetary ills at this early stage.   Among other things Willett also faults an overly eager Russian Central Bank too closely tied to the fortunes of its political masters in Moscow, granting money to regional banks freely for projects with no guarantee of return on the loan.

 The analysis in Willett’s study is based on false premises which if given the proper analytical framework are appropriate, or perhaps it was because of the premature release of the publication before Russian “Glasnost” really sank in and their economic activity became (mostly) transparent.  Regardless, his study perhaps rests on the faulty assumption that the 1993 hyperinflation was foreseeable (true) and preventable (false).  Using Monetarism, we can express this hypothesis appropriately.

 Monetarism as expressed by Milton Friedman is the theory that inflation occurs when money supply as dictated by governmental forces outpaces economic growth. 5  In a Monetarist economy the total value of all monetary instruments in circulation for an economy is equal to its total Gross Domestic Product or GDP.  As an example, taking the 2007 GDP of the United States, under an optimal Monetarist system the United States should as of 2007 have somewhere around 14 trillion dollars circulating around the domestic economy. 

 In Willett’s study he establishes a clear correlational trend between a low inter-bank interest rate, which is the main method by which central banks enforce monetary discipline on their host countries (higher interest rates mean that banks borrow less for fractional reserve purposes, and therefore the government prints less money to meet this demand), and rampant inflation in the Russian economic sphere.  However what is not listed in his case study is the comparison of GDP growth or shrinkage correlated with inflation.  

Berglor’s case study The New Political Economy of Russia gives us some startling statistics with which to work with in this sphere.  Between 1990 and 1995 the Russian economy almost halved itself, losing 40% of GDP by 1995 and remaining stagnant until 1998, at which point it began to make gains of roughly 5% annually.6   To lose 40% of GDP in less than three years is a catastrophic event that most countries would associate with a historical milestone like the Second World War, or the great depression.  It is not an unreasonable declaration to assert that the Russian economy was not so much crashing as it was evaporating.  Either through number-fudging on a massive scale followed by a massive and depressing reassessment, the sudden withdrawal of the government from all economic activity, or as a Marxist punctuation to Francis Fukuyama’s philosophical declaration was the end of history, Russian economic infrastructure halved itself almost overnight. 

For the most part the rates of inflation and GDP loss match up quite well.  The most inflation (2500%) occurred approximately November 1992, likely the point when the first truthful economic reports were published in Russia since the October Revolution.  The Central Bank then reacted to this approximately a year later in September 1993 when interest rates skyrocketed to the point that they were actually taking money out of circulation (because of the rapid fluctuations in inflation the inflation-adjusted interest rate ran between -100% and +200%) .   While the rates don’t necessarily correlate with a high degree of percentage increase (compare the 40% loss in total GDP with the 2500% inflation) they still form a general matching trend.  Loss of GDP devalued the Russian Ruble, and a poor monetary policy by the Central Bank which ignored the issue until it reached a political critical mass did the rest.   From 1990 to 1998, the Russian Federation was continually subjected to things becoming even worse than they already were, and 1998 would prove most painful of all.

 
Compared to the headaches of the 1993-1995 period the 1998 Ruble “Crisis” did not last as long, nor were its effects as chronically painful as those of the previous economic contraction (though it could be argued that because the prior crunch occurred so recently to the collapse of the Soviet Union, there was a negligible difference between a shortage economy and a hyperinflated one, versus the 1998 status quo).  What is largely agreed upon regarding what happened is this:

In 1997 the Asian financial markets of the Pacific Rim suffered a massive devaluation in all currencies which originated with government insolvency in Thailand.  Following the financial implosion, there was a speculator “run” on the Russian Ruble.  The Central Bank of Russia, trying to maintain a stable exchange rate so as to meet Russia’s obligations to keep a balance of payments to G7 nations responded by using foreign currency reserves to buy-back the currency.   This burned out Russian foreign currency reserves, and after another speculative run on the Russian Ruble which demolished the credit ratings that the Russian government had been desperately trying to achieve over the past 8 years.  Simultaneously resource commodity prices began to drop worldwide.  Meanwhile, the Ruble is kept on a standard exchange rate which makes Russian oil exports incapable of competition with dollar-valued oil exporters.  Russian exports stagnate.    To avoid being pulled into hyperinflation and a repeat of earlier economic problems the Central Bank allows the Russian Ruble to “float”, its value dictated by international exchange markets, and the value of the ruble quickly devalues until it settles in at a 30:1 exchange rate with the U.S. dollar by September 1999.   The Russian GDP  loses 5% for the fiscal year of 1998. 7 

 
 The simultaneous crunch of oil prices and the Russian situation in 1998 is noted often in publications discussing the issue, and the natural resource price crunch in general. In 1997 oil prices were up, and it was looking like the Russian economy would actually experience growth for the first time in a long while before the system was once again reduced to rubble.8  However the conclusion reached by the Saint Louis Federal Bank in the matter was that the 1998 ruble hyperinflation was due to factors unrelated to commodity pricing or monetarist theory.   Specifically: 

“After reviewing the three generations of currency
crisis models, we conclude that four key
ingredients can trigger a crisis: a fixed exchange
rate, fiscal deficits and debt, the conduct of monetary
policy, and expectations of impending default. Using
the example of the Russian default of 1998, we show
that the prescription of contractionary monetary
policy in the face of a currency crisis can, under
certain conditions, accelerate devaluation. While
we believe that deficits and the Asian financial crisis
contributed to Russia’s default, the first-generation
model proposed by Krugman (1979) and Flood and
Garber (1984) and the second-generation models
proposed by Obstfeld (1984) and Eichengreen, Rose,
and Wyplosz (1997) do not capture every aspect of
the crisis”9"
 
However the correlative value in the GDP contraction and modest inflation, compared with the 1993 crunch, seems to match up.  Using a simple formula of dividing the rate of inflation by the contraction of GDP we get a percentage of 50% inflation for every 1% of GDP lost in 1992 and 30% inflation for every 1% of GDP lost in 1998.   This is however without adjusting for IMF intervention in the Russian economy, which was invited by Yeltsin to help back the ruble and keep speculators at bay.  It is possible that foreign currency reserve support of the Russian Ruble kept some of the hyperinflation down, as well as a hyper-contractionary reactive monetary policy, which spiked between May and September of 1998. 
 Objectively, detached from specific circumstances and micro-analysis of specific areas of Russian economic history, GDP growth/stagnation and inflation have strong correlative values.  After the 1992 hyperinflation, Russian GDP stagnated at no loss and no gain, and inflation followed this path as well.  Along with tight monetary policy by the Central Russian Bank the 1994-1997 period was fairly non-eventful and inflation was negligible, just like GDP.  In this way, the Monetarist theory works well, in conjunction with a well-regulated and sensible monetary policy by the governmental authority.  

 Post-1998, Russian GDP growth has been steady at 6-9% annually, and inflation has raised an average of 10% annually as well.  The Central Bank has raised interest rates steadily over the years to approximately 6.25% in 2007 but some academicians theorize that the return to a non-floating policy of the Russian Ruble reduces the effectiveness of their efforts. 

 The other component of the hypothesis examines oil and natural gas as a part of the state apparatus and in the context of inflationary control and exchange rate anchor.  It is worth nothing that
Oil and Natural Gas production are considered to be approximately 20% of total Russian GDP  as of 2007 as a way of establishing just how important oil prices are to the prosperity of Russia’s economy.10  At 20% of GDP, a 50% drop in oil prices would mean a 10% slash in total GDP for the Russian Federation, a galling number that would send investors running at any speculation of such conditions.  In 1998, oil prices descended from 24$ to 13$11, roughly a 50% decrease.  Assuming the oil/natural gas industry of Russia was even half its current size, that would be more than enough to represent the 5% GDP cut the Russian Federation experienced in the same year.

 In general the Russian Federation’s prosperity and oil prices do seem to be intertwined.   When oil prices have been stagnant, Russian growth has been stagnant, the brief spike in oil price to 24$ in 1997 correlated nicely with the 5% rise in GDP predicted that quarter, and the collapse back to 13$ a barrel correlated strongly with the 5% decrease in Russian GDP, as well as the quick recovery of the Russian Economy in the 10 years since the Ruble “Crisis” and its general strengthening.  What is abundantly clear of course is that Oil and Natural Gas production is becoming more and more important to the prosperity of the Russian Federation regardless of past correlation.   The 2000-2008 trendline blatantly favors a verifiable link between the large increases in GDP growth and the continuing rise of oil prices worldwide.  Consequently, the Russian Ruble has been getting stronger and is down from its 1998 high of 35:1$ exchange and now exchanging at somewhere closer to 18:1$12.
 
 Oil prices per barrel have gone up almost 1000% in the past 10 years, which dovetails nicely with the 10% GDP increase annually the Russian Federation has experienced.   This begs the question of whether any other sector of the Russian Federation is productive at all or if it is regrettably a one-trick nation-state pony. 

 This of course, leads to the geopolitical ramifications of the oil and natural gas end of the problem with the Russian Federation… 

It is perhaps much to the late Milton Friedman’s chagrin that the free market he championed for the former Soviet States could be yoked so harshly to the natural resource that seems to be on everybody’s lips in the former Soviet Sphere (from Iraq all the way to Vladivostok).  The evolution of the Russian Federation into a “petro-state” seems inevitable with the coverage of natural gas and oil industry as a percentage of GDP. 

 It is also abundantly clear that the monetary authority in Russia is still no more effective than its Marxist-Leninist counterpart, the GOSBANK.  The Central Bank’s interest rate decisions are constantly reactive and never match any sensibility of long-term foresight, only rapid and overzealous interest rates briefly ratcheted up to levels that strip overabundant money supply out of the market.   With the continued centralization of power in the presidency of Russia, Willett’s thesis that a truly independent Central Bank is what Russia needs to fix its paltry monetary authority becomes more and more of a joke. 

 In most successful pre-20th century nation-states, surplus in natural resources has led to capital investment being placed into industrialization, jump-starting an industrial revolution from a bumper crop, essentially.  Russia however has likely suffered what some economists call the “Dutch Disease”13, an all-in strategy much ironically like Russian Roulette.  You can keep raising the stakes as much as your wallet will bear but eventually the payout will stop and the shock will be a painful one. 

The increasing overreliance on natural resource production for the income of the Russian Federation will result in more and more pressure by Russia to retain its sphere of influence, but this time not for reasons of ideological consistency or an intense paranoia of the West but because of what most intelligentsia are now calling “energy politics”.   Barring a massive divestment from natural resource production by the state-owned GAZPROM and investment in more technical and sustainable developments, the percentage of GDP related to natural gas and oil production has only one way to go: Up.   

 This means that contrary to the assertions of academic professors, the Russian state is fated for another hard knock in life.  We have all heard the rhetoric of the last few years, seen the movies of the 1980’s in post-apocalyptic conditions, usually precipitated by an energy crisis.  When, not if oil prices go down, the Russian GDP will collapse like a house of cards, which will in turn drive down the Russian Ruble back into hyperinflation like it suffered as the Soviet economy prolapsed into the Russian Federation economy. 

 Reasonable people should start asking themselves: What will the future leaders of the Russian state do to prevent that?  If economic history is any indication, it’s that the political leadership of Russia prefers the path of least resistance as opposed to wandering the desert for 40 years and finally emerging as a diversified economy, actually worthy of the title of a G8 Nation.  

Geopolitically, Russia is the only nuclear nation whose welfare seems to be entirely reliant on oil.  The theocratic Islamic Republic of Iran may soon change that, but even under the same metric, a bootstrapped Iranian nuclear program is nothing compared to the nation that gave us Tsar Bomba.  18 years ago the United States held its breath and waited for the dust to settle as the Soviet Union sorted itself out and made sure to account for all its nuclear weapons.   Unless the current Russian Federation breaks its current trend of more and more investment into natural resources, inevitably something will change.  It’s a principle of economics that generally capital drives an upward trend that takes the form of a sine wave.   A country with liquidity in its markets can handle that.   Can a Russian petro-state?

 

Bibliography

Establishing Monetary Stability in Emerging Market Economies Willett, Thomas D.

Boulder, Colo. : Westview Press, 1995.

The New Political Economy of Russia Berglof, Erik

Cambridge, Mass. : MIT Press, 2003.

Socialism; an economic and sociological analysis Von Mises, Ludwig

London, J. Cape 1936

A Case Study of a Currency Crisis: The Russian Default of 1998 Owyang, Michael. Chiodo, Abbigail.

Saint Louis, Missouri. 2002. Saint Louis Federal Reserve Bank.

Back to Basics Ebrahime-zadeh, Christine

Finance & Development Magazine, March 2003, Volume 40, Number 1

International Monetary Fund, 2003

http://www.bankofcanada.ca/en/backgrounders/bg-m3.html

Accessed April 23^rd, 2008, Personal Connection

CIA World Factbook: Russian Federation

Accessed April 22^nd, 2008, Personal Connection

Energy Information Administration website

http://www.eia.doe.gov/

Accessed April 23^rd, 2008 Personal Connection