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. Last Updated: 07/27/2016

Has Monetarism Failed?

Russia has had enough of "monetarism," a term used broadly here to refer to any attempt to control inflation by slowing the growth of the money stock. Boris Fyodorov and Yegor Gaidar are seen as the champions of this allegedly failed policy.


There was, in fact, an attempt at restraining the growth of money and credit in 1993, and it did yield some slowdown in the rate of price increase. However, the slowdown in inflation was accompanied by highly visible and undesirable side effects. One was a further drop in industrial output, to 57 percent of its 1989 level from 67 percent a year earlier.


Another was the emergence of a "payments crisis" -- a situation in which producers ship goods to their customers but are not paid for them, and, in turn, pay neither their own suppliers nor their workers.


The widely drawn conclusion is that monetarism did not and cannot work in Russia because of the "specifics of the Russian situation." Fashionably non-monetarist plans to save the economy have sprung forth from all sides -- from the prime minister, from the parliamentary opposition, from recycled Gorbachev advisers, even from the militantly pro-business newspaper Kommersant. These plans typically prescribe cheap credits, universal or selective price controls, subsidies to friends, new taxes on enemies, new limits on foreign trade, and closer regulation of economic life in general.


Last year's reformers, now out of power, warn that these plans will lead to the "Ukrainization" of the Russian economy. They are right. But those who insist that Russian specifics prevent monetary restraint alone from quickly bringing price stability and prosperity are also right, at least in part. But just what specific features of the Russian economy hamper successful implementation of monetarist policies?


We can start by looking at what happens in a normal market economy when the Central Bank tightens credit conditions. As their customers cut back their orders and pay their bills more slowly, firms have trouble finding cash to pay workers and suppliers. At this point, several key rationing mechanisms come into play to ensure that available funds flow to the most urgent needs.


As interest rates rise in response to the tightening of monetary policy, firms look for nonessential uses of funds that can be cut from their budgets. Long-term investment projects are put off, payrolls are cut, and dividends are reduced.


Banks and other financial institutions represent a second key rationing mechanism. As clients turn to them with urgent needs for funds, they must decide which firms are fundamentally sound and which have structural problems so severe that they are no longer good credit risks.


As some firms are driven to insolvency, a third rationing mechanism, bankruptcy, comes into play. When a firm ends up in bankruptcy court, its creditors, with the help of the court, must determine whether a greater part of its value can be salvaged through reorganization, or whether it should be liquidated.


Thanks to these credit rationing mechanisms, monetary restraint in a market economy does more than simply squeeze out inflation. It also calls firms to account for past mistakes and encourages healthy structural reform. Unfortunately, none of these mechanisms exists in Russia at present.


First, throughout 1993, real interest rates -- nominal interest rates minus the rate of inflation -- remained negative. As a result, neither in the private sector nor in the state sector did firms have any incentive to reduce demands for credit.


Second, there are no banks in Russia, at least as the term is understood in the rest of the world. The standard definition of a commercial bank is an institution that takes in deposits and uses them as a basis for extending loans. Although Russia's so-called commercial banks no doubt provide their customers with many useful financial services, few if any have balance sheets dominated by loans and deposits. Some accept deposits and provide their customers with payment services, but make few if any loans.


Others make loans, but on the basis of subsidized credits from the Central Bank rather than depositors' funds. In neither case are these institutions in a position to serve as cold-eyed arbiters of who gets scarce credit and who does not.


Finally, there is no working bankruptcy mechanism. Firms that don't pay their workers or suppliers face no credible threat of legal action, and their customers, in turn, can refuse with impunity to pay them. Two more specifics of the Russian economy make matters worse. One is the mind-set, carried over from the days of the command economy, that everything will be well as long as physical flows of goods continue -- the corresponding flows of payments are a mere detail. The other is inflation itself, which, especially when combined with negative real interest rates, provides an enormous incentive to delay any payment of any kind.


When monetary restraint is applied in such an economy, it is small wonder that things go wrong. Inflation slows, but not by as much as is hoped because ballooning inter-enterprise credits cushion the deflationary impact of tightened Central Bank credit. Furthermore, there is great pressure on the Central Bank sooner or later to settle these ad hoc credits by granting new credits of its own, thereby once more spurring inflation.


Finally, when credit-rationing decisions are politicized, there is no tendency for scarce credit to go to those who need it most, and hence, no pressure for structural reforms. Unfortunately, neither last year's monetarists nor this year's born-again central planners are adequately addressing these problems. Stability and prosperity will have to wait until they do so.





Edwin G. Dolan is president of the American Institute of Business and Economics, an American business school in Moscow. He contributed this comment to The Moscow Times.