Friday, August 29, 2008

Putin I and Putin II

You hear a lot of discussion recently about Russia's new assertiveness (sometimes a different description is used!). And it is obvious that high oil prices have a lot to do with it. But this picture produced by my colleague Cliff Gaddy puts it neatly in perspective. He compares Russian government foreign debt with its foreign exchange reserves.
In the Putin I regime, Russian government debt was much larger than foreign reserves. In Putin II we have more than a complete reversal (though I should note that foreign debt of state-affiliated companies would add to government debt -- presumably if Rosneft cannot pay its Eurobonds the government will). In the Putin I regime the west had lots of leverage on Russia. Now that leverage is gone.

Friday, August 22, 2008


Jim Hamilton has a good post on speculation and oil prices. It is tempting for politicians to blame high oil prices on speculators. They never seem to blame falling prices on speculators.

It is important to remember that the contracts that are being traded are for future oil deliveries. So it is important to think about how this could effect the current price. Think about tickets for a baseball game. If there is high demand for a future game does that cause the price of tonight's game to rise? That could happen if the owner reduced sales of tickets for tonight's game, but why would that happen? You cannot save unused seats!

With oil, of course, you can save it for future use. And that would raise the spot price. But then we would see inventories of oil increase. And as every economist has argued, we have not observed this as oil prices have risen. That is why it is hard to see how oil prices are being driven higher by speculation.

Tuesday, August 19, 2008

Financial history and analogies

Barry Eichengreen has an interesting article in the FT about analogies with previous financial crisies. Just as Generals sometimes fight the last war, central bankers having learned about previous financial crises may interpret events through the lens of history. But it is important to get the analogies correct. Is this another Great Depression? Certainly we are not experiencing any deflation! One thing is clear, however. The fact that many emerging economies tie their exchange rates to the dollar means that our attempts to deal with our financial crisis -- by easing credit -- transmits the shock to those countries. We are exporting inflation, and given the fall in the dollar we are importing it right back!

Rogoff: Worst is yet to come

Professor Ken Rogoff of Harvard, former Chief Economist at the IMF (and International Grandmaster of Chess) forecasts a worsening of the financial crisis:
The U.S. is not out of the woods. I think the financial crisis is at the halfway point, perhaps. I would even go further to say ’the worst is to come’

Rogoff anticipates that another large financial institution is likely to go bust. Exciting times ahead?!

Monday, August 18, 2008

Gas Money

Hyperinflation in Zimbabwe reached 12.5 million percent in May and is probably higher now. There is a shortage of money and the government has made use of the US dollar illegal to avoid currency substitution. As a result, according to this article, Zimbabweans are using gas coupons -- claims on liters of gasoline.

This is not barter. It is the development of an alternative money, what is being used for transactions are the claims to gasoline, the gasoline itself is not used as money (that would really be explosive!).

This brings to mind the use of brick money in Russia in 1992. During the high inflation brought on by excessive money growth and price liberalization, a shortage of cash arose (why? because prices grow even faster than money in such periods). Enterprises in the Urals resorted to trading claims on bricks. Why bricks? They are easy to count, uniform in quality, easy to store, and useful. But as with the gasoline coupons, it was the claims, not the goods that were actually traded.

Dr. Doom

The NYTimes Magazine has an interesting profile on Nouriel Roubini, economist at NYU, and founder of RGE Monitor. Roubini has an interesting background but it notable for having emphasized the likelihood of a financial crisis and knock-on effects on the economy for quite a while.

See also Krugman's note that corrects some of the misleading journalistic discussion of the article. As Krugman notes, financial crises are hardly an unstudied area in economics as the NYTimes article asserts. I even teach a class on financial crisies.

One also has to take issue with the idea that it is the absence of equations that characterizes good work on crises. The important point is to study the problem, there are plenty of good papers that study crises that develop interesting models. Without them we really do not understand what we are talking about.

Thursday, August 14, 2008

Energy Independence

Robert Higgs has a nice column on the folly of the notion of energy independence. Suppose we substitute bananas for energy:

If we were talking about bananas, everybody would see immediately the foolishness of seeking “banana independence.” Nobody would fall for half-baked arguments about our addiction to foreign bananas or our love affair with banana bread. It’s obviously uneconomic to grow millions of bananas in this country; it could be done, but doing it would entail much greater costs than buying them from producers in places better suited to their production (that is, places where they can be produced at lower opportunity cost).

The argument with regard to oil, or anything else, is identical.

Moreover, even if we produced all our own oil (or bananas) we would also have to erect a wall to prevent exports if we truly wanted to be insulated from what happens elsewhere. Oil is relatively easy to ship, so if prices rise elsewhere they are going to rise here as well unless exports are forbidden.

I think Higgs is wrong, however, when he writes:
The U.S. government may wish to exercise hegemony in the Persian Gulf so that politically well-connected big oil companies can reap a bigger share of the handling income from producing and transporting the Gulf oil (but if these companies didn’t perform these tasks, other companies would do so).
This confuses the source of oil company profits. Big profits arise when world oil prices rise because the companies produce oil as well as buy from OPEC. Hence, they earn rents on the oil that is produced at lower cost than what they must pay OPEC producers. They are the indirect beneficiaries of price increases because they have inventories of the commodity as well. Of course, if OPEC produced at full bore and drove prices down they would lose since most of their low cost oil was produced long ago.

Statistics and Value Added

John Kay has a nice column in today's FT on economic statistics. The important point is that economic statistics are the product of our conceptual apparatus. Bushels of wheat are easy to measure, but value is an economic concept. Hence, complications can arise, especially when measuring services. One has to be skeptical when an odd measurement confounds common sense.

Friday, August 1, 2008

Protection Racket

Many people wonder why Putin is willing to engage in activities that seem inimical to Russia's economic interests. These comments tend to miss the point of what Putin cares about. Cliff Gaddy sends in this comment that has it exactly right:

People ask, Why would Putin allow this to happen? It is not in Russia’s or his own interest. Foreign investors will be discouraged, oil production will suffer, and so on. It doesn’t make sense.

Thinking in these terms confuses efficiency as seen from the economic point of view and what might be termed political efficiency. Putin does indeed desire economic efficiency, that is, continued production of resource rents. But his first priority is control of the use of those rents – political efficiency. And here, informal taxes have two big advantages for Putin. First, informal taxes can be collected and redistributed much more flexibly than formal taxes. He and his inner circle need to be able to channel resources to precisely the people and purposes they choose, when they choose. One might object that they can do that anyway with the budgetary flows (the formal taxes) at their disposal. But those flows are not nearly as flexible. Putin is very concerned about his ability to react flexibly to changing circumstances. He needs to call on key actors to channel resources quickly.

The second advantage of informal taxes is even more important. Informal taxation is a key component of the property rights protection racket – Putin’s mechanism for manipulating the behavior of the resource owners. The world of informal taxes is a world of quasi-legality at best. Keeping companies in that world gives Putin leverage. It is absolutely a good thing for Putin that companies engage to a controlled extent in various forms of illegal payments such as bribes, kickbacks, padded contracts, and the like. Precisely because the actions are illegal, they make the companies vulnerable to the tax authorities and the police. Paying informal taxes forces companies to violate laws. And that is the point. The evidence of their financial crimes is collected at the same time that their money or favors are collected. The individual chiefly responsible for this branch of “Russia, Inc.” is Putin’s no. 2, Viktor Zubkov. Since his days as founder of Putin’s Financial Monitoring Agency (a “financial intelligence service”, as Putin once described it), Zubkov has been the personal repository of information that can destroy any major company and any wealthy individual in Russia. He can see to it that real – not fake – charges are brought against anyone, at any time. This is the way the Protection Racket works. Informal taxation is at its heart.

In a ruling handed down by the United States Supreme Court in 1819 (“McCulloch v. Maryland”), Chief Justice John Marshall wrote the famous words that apply to any society: “The power to tax involves the power to destroy.” In today’s Russia, the discretionary power to informally tax is an equally potent instrument of destruction and, more important, of control.

Foreign Investment and Lena Goldfields

There is a lot of discussion today about how Putin's actions will hurt foreign investment in Russia. Does Putin just ignore the impact? Does he not care? I think there is another explanation at work here. Gaddy and I call this the "Lena Goldfields phenomenon," and it is discussed in our forthcoming book (Russia's Addiction: The Political Economy of Resource Dependence). Let me give a brief explanation here and then quote from the book.

The Lena Goldfields phenomenon is a recurring theme in western interaction with the Soviet Union and Russia. It is the belief that the rules will soon change to favor foreign investors and that the rights of those investors will be protected. This belief recurs despite Russia’s long history of defaults on foreign debt and its shabby treatment of foreign investors in the past (for an interesting article on Russia's history with debt repudiation, see this article by Yulia Sinyagina-Woodruff). The Lena Goldfields case is the classic example and shows how willing foreign investors can be.

Here is the excerpt from the book:

Lena Goldfields was an English company set up in 1908 with heavy ownership from other Western countries. It bought out an existing Russian company originally founded in 1855. It was quite profitable until it suffered during episodes of violent labor unrest before World War I and then the war itself. The Bolsheviks nationalized the company in 1918.

The story become interesting as the Soviet Union launches the New Economic Policy and the post-Rapallo wooing of foreign capital. The USSR now promises that foreigners can come in and be allowed to invest in all kinds of industries; including highly profitable ones such as mining and metals, and that they will be allowed to repatriate profits. They need only pay regular taxes in the USSR.

The owners of Lena Goldfields fall for this lock, stock, and barrel. This is 1922-23. Recall, now, that five years earlier they had lost everything they had in Russia. So what do they do? First, they renounce all claims on the Soviets for their nationalization losses. In other words, they give the Soviets the market value of the original Lena Goldfields. Then they spend £4.5 million to go around in the West and buy out all the shareholders of all of Lena’s Russian subsidiaries (which also had been nationalized). The sole reason for doing this is so that they (Lena’s financiers) could then legally renounce all the claims those companies might have on the Soviets. Then they agree to invest a massive amount of additional capital to modernize the mines.

In return, they actually believe – because that’s what the concession agreement that they finally conclude in 1925 says – that they will be allowed to control of “30 per cent of the gold, 80 per cent of the silver and 50 per cent of the copper, lead and zinc production in the Soviet Union.” [Veeder 1998: 758]

To understand how crucial this is, substitute “oil” and “gas” for “Gold,” “silver,” “copper,” and so on and think about the situation today. Those metals were the oil and gas of the 1920s – the almost exclusive source of foreign exchange for the state. And the Lena owners think the Bolsheviks are going to let them control it all. (They perhaps fail to notice that the entire Soviet economy at that time was being supervised by Felix Dzerzhinsky, in his dual role as head of the Supreme Economic Council and head of the Cheka. Or, of course, maybe that is exactly why they think they have a good deal: their own concession agreement is countersigned by Iron Felix.)

So why did the Lena owners do this? As Veder (p. 757) notes, “For Lena Goldfields’ financial backers this [spending £4.5 million to buy out the subsidiaries’ shareholders] was a large investment, in addition to the substantial investments already lost upon Soviet nationalisation; and it reflects how both English investors and the Russian exiled community still retained the hope that the Bolshevik regime would collapse or at least mutate into a more benevolent form, allowing nationalised properties to be returned to their private owners [emphasis added].”

In other words, Lena’s owners were making exactly the fatal mistake that Khodorkovsky made: they were betting that the rules of the game were going to change. They were so sure that the system was going to “mutate” in the right direction that they bet the house on it. But the mutation went in the opposite direction.

To be sure, it for a while looked like they had called it right. The number of other companies who sought and were awarded concessions boomed. In 1923-27 the Main Concessions Committee (“Glavkoncesskom”) received over 2,000 applications. About 100 foreign concessions were operating in mid-1928. At the same time, the Soviet government announced it was going to further liberalize the concession rules; it needed even more foreign capital. A brochure that the Soviets published in the U.S. in 1929 reported that the First Five Year Plan specified a list of available concessions, broken down by type of plant or facility. It lists over 200. [The Soviet Union: Facts, Descriptions, Statistics, 1929, Soviet Union Information Bureau, Washington D.C.]

By early 1929 Lena had produced gold worth £3.6 million (about a quarter of total Russian gold production). Its profits were only £760,000. But it had only been able to repatriate £170,000. That left the company in financial trouble. It gets into debt and fails to make the royalty payments it owes the Soviets. At the same time, thanks to the labor problems described by Bazhanov, the company fails to fulfill the production quotas it had committed to. So the formal breach of contract is a reality. After that, it’s a slam dunk for Dzerzhinsky & Co.

“From the autumn of 1929, Lena Goldfields was increasingly subjected to rough treatment,... On 15 December 1929 matters between Lena Goldfields and the Soviet Union came to an abrupt head, with massive raids carried out by the OGPU throughout the night on Lena Goldfields’ establishments in Siberia, Moscow and Leningrad. Its papers were confiscated; and its senior officers and staff arrested.” [Veeder 1998]

Lena Goldfields was the beginning of the end. In November 1929 “the chairman of the Council of People’s Commissars (A. I. Rykov) declared to the Main Concessions Committee ... that the Soviet economy would henceforth do ‘no business with counter-revolution’. There was to be no room for concession agreements with foreign capitalists. Accordingly, these foreign concessions began to disappear; by 1936, only 11 remained; and by 1938, none....” [Veeder 1998]

There is an interesting footnote to this case.[1] Bazhanov (politburo secretary under Stalin) claims that after the owners complained to the British Government, the Politburo discussed the defense of the Soviets by Ramsey MacDonald, leader of the British Labor Party. He quotes Bukharin as noting that “the most remarkable thing is that these cretins in the Labor party have taken our arguments at face value…I propose that we send Comrade MacDonald to be secretary of the Party committee in Kyshtym, and appoint M. Tomsky prime minister in London (198).” Bazhanov claims that when he fled the Soviet Union he had the Politburo’s written decision on this matter and that he showed the document to British Intelligence, show shared it secretly with MacDonald, thus accounting for the latter’s break with Russian communism before he became Prime Minister.

[1] See Boris Bazhanov, Bazhanov and the Damnation of Stalin, translated by David Doyle, Athens, Ohio University Press, 1990: 197-199. He discusses the general policy of attracting concessions and then using labor actions to cause violations of the concession, as Politburo policy (99).

Belief in the Lena Goldfields fantasy is a recurrent theme among western investors when they view Russia. And Russian governments understand this. In particular, they know that reputational concerns are not decisive when it comes to western investors. Russian governments know that there is always the perception that tomorrow is a new day, or that “the rules will change when we invest.” Hence, the cost to the Russian government and to the Russian economy of crackdowns on foreign investors is much smaller than it would be if reputation mattered in the way that economists usually suppose it does. The penalties – lack of access to foreign capital markets, or falls in FDI – are always short-lived. The lure of Russia is too great for foreign investors to stay out very long. Hence, the Russian government can crack down with relative impunity on foreign investors without much cost.