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. Last Updated: 07/27/2016

IMF Forgets Deflation




Without new IMF loans, the Russian government faces a default on its Eurobonds and funds borrowed earlier from the IMF, a humiliation it wants dearly to avoid. This gives the International Monetary Fund substantial leverage over Russian economic policy. But just when its influence is strongest, the IMF may be giving Russia bad advice.


The first element of bad advice concerns monetary policy. The IMF sees itself, first and foremost, as a bulwark against that great scourge of the past half-century, inflation. Yet increasingly, observers see the world as threatened not by inflation, but by its opposite, deflation - the kind of vicious downward spiral of prices, money and output that has not been felt since the Great Depression of the 1930s.


A recent cover story on the subject in The Economist notes a sevenfold increase in stories devoted to deflation in the world financial press. However, most of these stories focus on Japan and the European Union. Can we even imagine deflation in Russia, where prices have risen 10,000 times in the past decade and have doubled again in the past six months? Astonishingly, we can.


No one was surprised when last August's devaluation led to a jump in the price level, but careful observers noted that there were two different types of inflation to worry about. One was the direct impact of the devaluation on the prices of imported goods. Although almost impossible to avoid, this aspect of inflation had an inherent limit at roughly a doubling of the price level.


The other concern was the secondary inflation that would have occurred had the new government unleashed the monetary printing presses to cushion the social effects of the crisis. To the surprise of many, the monetary policy of Prime Minister Yevgeny Primakov's supposedly populist team proved stalwart as could be.


From July through October, the Russian money stock actually fell. Even by December, it had risen by a paltry 7 percent from its precrisis peak. These are nominal figures. A better measure of the monetary resources that firms and consumers have at their disposal for everyday needs is the real money stock - that is, the nominal money stock adjusted for the effects of inflation on the purchasing power of each ruble. The real money stock fell by fully 40 percent from June through December.


Even more disquieting are changes in the composition of the money stock. The standard measure of the money stock, called M2, includes both paper currency and bank deposits. While consumers use the former as their everyday medium of exchange, the transactions among business firms in a healthy market economy depend almost exclusively on bank deposits. However, as the crisis unfolded, composition of the Russian money stock shifted sharply from deposits to currency. From July to November, currency's share of M2 rose from an already high 35 percent to 44 percent. (In the United States, paper currency accounts for just 10 percent of M2.) By December, the real value of bank deposits was less than half its peak in February 1998. Further adjustment for frozen deposits in failed banks would make the numbers look still worse.


The shift from deposits to currency has an ominous precedent in American history, from 1929 to 1932. Just as in Russia, the flight to currency was the result of a banking crisis. Americans in the 1920s, like today's Russians, had no deposit insurance to protect them, so when banks began to fail, anyone who got to the teller's window in time withdrew as much currency as possible. In his "Monetary History of the United States," for which he won a Nobel Prize, Milton Friedman singled out the failure to cope with the banking crisis and the resulting shift from deposits to currency as the leading monetary policy blunder of the period.


Meanwhile, back in Russia, the IMF's single-minded focus on inflation is causing it to send the wrong signals in other areas, as well. Last month Jorge Marquez-Ruarte, deputy director of the IMF's department dealing with Russia, wrote a letter to Central Bank chairman Viktor Gerashchenko - a letter that was quickly circulated in the State Duma - expressing concerns about legislative proposals that would subject monetary policy to parliamentary control. Now, Central Bank independence is fine in principle, inasmuch as elected politicians everywhere are notorious for printing money to buy votes whenever an election looms. But Gerashchenko appears to have taken Marquez-Ruarte's letter - and perhaps it was meant that way - as a pledge that the IMF would help hold critics at bay while the bank carried on business as usual.


Unfortunately, the last thing Russia needs is business as usual at the Central Bank. Right now, a much bigger threat than inflation is the runaway corruption of government institutions that seem devoid of checks and balances. In defending Central Bank independence at any price, the IMF appears willing to conspire in covering up corruption allegations, of which there are new examples almost every day - offshore GKO scams at FIMACO, huge interest-free deposits at foreign affiliates with mysterious links to Russian oligarchs, a license to steal issued to a Swiss affiliate of Aeroflot, and others.


What the Central Bank needs is not independence but a calling to account. The IMF should not sign off on the Duma's self-serving aim of subjecting day-to-day monetary policy to political control, but should join the chorus calling for oversight and transparency. It should use the extraordinary leverage it has by refusing new loans until the Central Bank has accounted for the billions of dollars it has touched since the day it was founded. If the price of effective oversight is a loosening of monetary policy, so be it. Monetary policy is too tight as it is.


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