When History Repeats Itself

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Despite plans to support financial markets by providing as much liquidity as needed to calm them, the U.S. market has remained stagnant for a third consecutive month, with the Dow Jones Industrial Average fluctuating at around 11,000. The situation is largely the same in Britain and other major markets, and the general trend since the start of the year has been downhill.

Almost every week brings news about more failing financial institutions, and the United States' $700 billion bailout plan may not be sufficient to stabilize the financial industry, especially given that banks, hedge funds and insurers have yet to report third-quarter financial results. This quarter appears to have been extremely turbulent with respect to exchange rates and commodity prices, and liquidity was not easily available. More surprises can be expected in October.

The U.S. dollar has seen several weeks of fast and impressive appreciation versus the euro, pound and several other major currencies. In a single day, on Sept. 22, oil prices saw an equally fast and impressive fall of nearly $30 per barrel, a previously unheard of pace. Other commodity prices headed the same direction as a hedge against a potential crash of the dollar -- the price of U.S. authorities' unprecedented support of the financial industry.

The ability of oil and other commodity prices to move so fast and the fact that markets view the same information differently on different days clearly illustrate that the global economy does not lack money, which was and is available in huge quantities. The unprecedented 8 percent to 9 percent rise in European stocks on Sept. 19 is another indication that money abounds. What is scarce is confidence, and printing more money may not necessarily help to restore it overnight.

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Meanwhile, it looks like the U.S. administration is now doing exactly what it advised the Russian government against doing in the 1990s -- not to subsidize the domestic economy via negative real interest rates or wider fiscal deficit. At the same time, international financial institutions such as the IMF are expressing support for U.S. authorities, while in the 1990s they were very critical of the Russian government. It appears that U.S. authorities have attempted to borrow some moves from the Russian government's playbook that contributed to high inflation in the 1990s and the permanent depreciation of the ruble -- namely, settling mutual nonpayments in the financial system and monetizing part of them.

A number of distortions emerged within the Russian financial system in the 1990s as a result of the rather toxic combination of an extremely loose fiscal policy and tight monetary policy, including the emergence of inter-enterprise arrears. Generally speaking, credit was not available for the rest of the economy because of the tight conditions on money markets, where all available cash was sucked by the government into short-term and high-yield bonds, called GKOs. This lack of cash was compensated by a rapidly growing supply of money substitutes, such as promissory notes and arrears, so that eventually the stock of money substitutes exceeded money supply.

Not surprisingly, inflation remained high because the Central Bank was never able to control the emission of these money substitutes. It was not a major problem as long as they circulated within the corporate and banking sectors, but once companies had to pay taxes and wages, cash was desperately needed. As credit was not available, tax and wage arrears kept rising as well, until at some point the authorities had to intervene to settle mutual inter-enterprise arrears and monetize the net stock of money substitutes. Obviously, every time this happened, inflation gathered momentum.

The U.S. Federal Reserve and Treasury face similar problems these days. They need to eliminate the toxic debt of financial institutions, reduce the stock of "virtual" money, such as various structured products and derivatives, which contain this toxic debt, and eventually monetize that stock of "virtual" money created by private financial institutions. This is a clear reminder of Russia's arrears and promissory notes of the 1990s. This means that the U.S. public debt ceiling has to be raised significantly and the fiscal deficit will widen, in which case it is hard to envisage a strong dollar -- unless the rest of the world, particularly the eurozone's economy, demonstrates much worse performance.

While Russia's history from the 1990s is repeating itself on American soil, this time around Russia may come out on top, or at least find some relief following its markets' painful collapse in August and September after being hit by an extremely unlucky combination of domestic -- in fact, manufactured -- and external problems. The domestic issues included the Mechel affair, the shareholder disagreement at TNK-BP and the military conflict in Georgia. Chief among the external factors was the U.S. dollar's meteoric rise against world currencies and the fall in commodity prices. Global financial instability caused capital outflow from Russia, as well as from other emerging markets, which in turn resulted in a liquidity squeeze on Russia's money markets and soaring overnight rates. If the dollar weakens and commodity prices go up, the direction of capital flows may reverse and the Russian market can expect some relief.

It looks as if the Russian market has neared rock bottom, and the chances for a rebound are high. Before trading on Russian stock exchanges was suspended two weeks ago, the capitalization of the Russian market fell dramatically, to around slightly over $700 billion, which was very close to the total stock of money supply. In the past, money supply always represented a rather strong support level for the market. The P/E ratio was also very low -- below four. That said, the chances that the Russian market will grow are high, especially if capital flight stops or turns to inflow, which is possible in the case of a weaker dollar. However, one should not expect an accelerating rally in Russia because the global market trend remains downward.

The only scenario under which the Russian market could continue its descent is one in which the ruble depreciates, which in the current environment does not appear likely. With the oil price staying at around $100 per barrel and the current account surplus remaining robust, Russian authorities have huge reserves and no intention to devalue the ruble.

Yevgeny Gavrilenkov is managing director and chief economist at Troika Dialog.