Streetwise Professor

LaRussaphobe pointed me to this interesting post from the Conde Nast MarketMakers blog.* The post discusses credit spreads for BRIC countries (Brazil, Russia, India, China). These credit spreads measure the creditworthiness of the sovereign debt on each of these countries. The higher the spread, the bigger the market’s estimate of a default (and/or the greater the market’s estimate of the loss conditional on default.)

You will note that as the credit crisis has exploded since late-August, all of these spreads have blown out, meaning that the market estimates that their risks of default have exploded. And surprise, surprise, surprise (cue Gomer Pyle voice), guess whose risk exploded most? Your favorite country and mine, Vlad’s paradise, that island of tranquility in troubled economic times.

In a nutshell, the market has deemed Russia the junkiest of the junky BRIC sovereign credits. And to think, this is the spread on government debt, the government that is sitting on $500 billion. Think of the market’s assessment of the credit risk of the “private” borrowers, eg Deripaska, Fridman/Alfa, Gazprom, Rosneft who are queuing up hat-in-hand to get charity from that government. Well, perhaps one reason for the wide spread is that market participants estimate that the $500 billion will be largely blown bailing out the oligarchs to keep strategic “crown jewels” out of the hands of the cursed foreigners.

Excellent MarketMaker blogger Felix Salmon expresses surprise at Russia’s poor performance relative to Brazil: “So the fact that it’s now 500bp wide of Brazil is kinda crazy. After all, they’re both mainly commodity plays, and their stock markets have both been devastated. But the credit markets show a huge distinction between the two countries which isn’t easily visible elsewhere.”

Not crazy to me, Felix. You’ve focused on just the economics (“both mainly commodity plays”) and missed the political risk angle. My conjecture is that the differential spread is the market price of political brittleness, weak institutions and property rights, corruption, and the absence of a rule of law. Now, Brazil is hardly Adam Smith’s vision of a classical liberal state, but it is miles ahead of Russia in that regard. Trying times test institutions, and times are now tough. The credit swap market is putting its money on the proposition that the current strains will overwhelm Russia’s political, legal, and economic institutions. That as a result, (a) the $500 billion plus that Russia has amassed in the seven fat years is at extremely high risk of disappearing down ratholes, leaving little behind to pay sovereign debtholders, and (b) the prospect that the gravy train is ending will spark political turmoil and infighting that threatens political stability in Russia, and sovereign debtholders hate political instability.

There are numerous stories on the web that help flesh out that story. Indeed, there are too many to mention, so I’ll just pick a few. First, this piece by Robert Skidelski in today’s FT:

Russia carries a heavy burden of political risk. This is the real economic legacy of the Putin years. Mr Putin does not understand the need for a degree of consistency between economic and foreign policy: or rather the reconciliation he has sought has been based on Russia’s energy windfall. If this has now ended, as seems likely, the key assumption of his politics – that Russia can use its energy power to boost its world power without paying much attention to the sensitivities of anyone but the Russian electorate – has been destroyed.

Russia needs to scale down its geopolitical ambition to its real weight – that of an emerging economy with only 3 per cent of the world’s gross domestic product and a quarter of America’s living standard. Also, it desperately needs to develop its human capital. The Putin era is over but Medvedev’s has not begun. This is the real Russian crisis.

(The last bit on human capital doesn’t relate to the political risk theme, but it does agree with what I’ve been arguing–not without opposition, to be fair.)

Then there’s this report describing how Russia is riding roughshod over the rights of minority foreign investors to save an oligarch (Mikhail Prokhorov) by rigging the game to allow him to escape his obligation to buy out minority investors at the price that he paid to acquire a controlling interest in power generator TGK-4. That’s not something you do when you’re thinkin’ ’bout tomorrow. If you are thinking about the future, you don’t want to do something that so damages your reputation with foreign investors. But reputation is about the future, if you are in sauve qui peut mode, it’s all about today.

One last gem, this one from the WSJ. VEB has extended a $4.5 million dollar to Rusal and Deripaska. But the rules said that the VEB assistance was limited to $2.5 billion. Rules? We don’ need no stinkin’ rules:

With the $4.5 billion Rusal loan, VEB appears to have made an exception to internal rules that limit lending of more than $2.5 billion to any one borrower. Norilsk, a major platinum producer, is considered strategic by Russian authorities. Without commenting directly on Rusal, Mr. Dmitriev said in an interview on a state-run news channel that the bank’s board — where Prime Minister Vladimir Putin is chairman — has the authority to make exceptions.

I’ll bet he does.

Both the Rusal and TGK-4 “exceptions” are only the most flagrant illustrations of the complete lack of any stable, rule-driven (and hence predictable) governance. Instead, they show that winners and losers are determined arbitrarily as a result of the exercise of influence and the exchange of political favors. They demonstrate that the system is one of personalized rule, with Putin exercising the ultimate power like the Godfather dispensing his favor on the lucky few. The Rusal exception also shows that Putin is willing to pay up to keep the “crown jewels” in Russian hands. That means that with various Russian companies owing well over $500 billion in foreign debt, there is a high risk that Russia’s reserves will be spent keeping control of these companies in Russian hands–another political decision, and one that just might be in the interest of connected people in the government. (BTW, it’s pretty sad that in the 2000s that an aluminum company is a country’s crown jewel. Think anybody in the US thinks that about Alcoa?)

In short, these episodes illustrate perfectly, Felix, why Russia trades at a 500 bp premium to freakin’ Brazil, of all places.

* I can just picture commentor David, and his fellow gang members (he does admit that he is a member of a group, and I have received emails from others expressing similar views), sitting somewhere in Poland or points east, saying “OMG, I just KNEW IT! Pirrong and LaRussaphobe ARE card-carrying members of a vast anti-Russian conspiracy!!!” You can change your drawers now, Dave, but I’m sorry that I’ll have to disappoint you. LR sent me an email, from the same email address that’s on her website, [email protected]. She signed it Kim. No hint of her/his/it super-secret identity. The email reads, in its entirety (excepting the salutation and signature, and the MarketMakers link that I’ve posted above): “Can’t make heads or tails of this, thought you must be able to.” Pretty loose association, don’t you think? Or, maybe that was code. But I never got my decoder ring, so I’m at a loss. And, to my disappointment, there’ve been no PayPal alerts telling me that money has been sent to me from shadowy sources to compensate me for my work for the conspiracy. Guess I’ll have to try harder.

The media’s slavish devotion to Obama hardly deserves comment, but the LA Times has truly distinguished itself in its eagerness to sacrifice principle for political expediency. These stalwart defenders of “the public’s right to know” when it comes to disclosing sensitive national security information, steadfastly refuse to release even a transcript of a video tape of a party honoring radical Palestinian academic Rashid Khalidi which Obama attended, and at which he delivered a testimonial to Khalidi.

The LAT has offered a menu of explanations/excuses–always a tip off to a lie. The first was “well, we reported on it, so we’ve fulfilled our obligation.” In their own words: “It sounds as if you don’t find ‘mere reporting’ to be enough, but The Times is not suppressing anything.” So in other words, the paper’s motto is: “All the news that we deign to give you.” The lame-o, blow off response begs several questions, the most important of which is: “You’ve reported something, but have you reported completely?” And, how can the Times not be suppressing “anything” if it refuses to release the entire tape? In their twisted logic, a piece is the whole: If we report on a part of something, but leave out something, we haven’t suppressed anything! We’ve told you the whole story! By analogy, if an LA Times editor gives give a beggar a bone, he’s actually given the poor mendicant a steak dinner. Maybe the LAT should get a clue from Paul Harvey, and tell us “the rest of the story.” My guess that that will happen, either (a) when Hell freezes over, or (b) next Wednesday.

That certainly wouldn’t fly in a court. The oath says, “Tell the whole truth.” The LAT is giving us part of the truth, and telling us to pound sand about the rest. The partial truth is often worse than a total lie.

It appears that that risible “defense” is no longer operative, so the Times has switched gears. It now wraps itself in sacred bargains struck with confidential sources: The Times “did not publish the videotape because it was provided to us by a confidential source who did so on the condition that we not release it.”

This violates the “you can’t be a little bit pregnant” principle, and completely contradicts the original justification. The Times already reported on, and quoted from, the tape–they admitted that in their original defense (not that they could deny it). So, they’ve already violated their sacred trust with Mr. LA Confidential. Maybe you guys haven’t heard yet, but you can’t get back your virginity. You lost that when the article on the event first ran.

Since the serial explanations are clearly bogus, the only possible conclusion is that the LA Times has no justification for its actions, other than that the tape would damage Obama’s prospects, and that the Times cannot abide that.

Once the phrase “military intelligence” was the standard joking illustration of an oxymoron. That phrase should be replaced by “journalistic ethics.” Sadly, that’s no joke.

I’ve argued that the current financial strife in Russia is an opportunity for sharks to take big bites from state funds, for the connected to get at the various reserve funds that have tempted them for a long time, but have been out of reach until now. Pavel Baev’s recent piece in the Eurasian Daily Monitor agrees:

All these voices are lines in a long rhyme that invariably ends with the reference “… in the house that Jack built,” and everybody in Russia knows who the architect in question is. That Vladimir Putin has never been able to admit a mistake is only part of his motivation for stonewalling the analysis of the unfolding disaster. A greater part of this determination comes from the need to keep the system of unaccountable redistribution of financial resources going for as long as possible, while the key players seek to compensate their colossal and totally unexpected losses.

Two features of this desperate looting of fast-shrinking reserves came into sharper focus last week. First was the mind-boggling scale of the external indebtedness of Russian companies, not only of all state-owned energy giants like Gazprom and Rosneft but also private “oligarchic” empires close to the Kremlin. The sharp fall of their market capitalization has triggered many “margin calls” for repaying the borrowed money since the collateral has lost value. As a result, Russian “champions” have to pay back up to $210 billion by the end of 2009 (The New Times, October 20). The political decision to rescue the loyal entrepreneurs by providing $50 billion for refinancing their foreign debts can solve some immediate problems, but the applications have already exceeded the designated sum, and many investment programs that are supposed to support Russia’s continuing growth, for instance in the newly-privatized electricity sector, have been gutted.

The second feature is the spectacular increase in corruption schemes and channels in the emergency situation of siphoning off hard-currency reserves that still amount to half a trillion dollars, which is approximately equal to the corporate debt. The decisions about rescuing banks that are known to be “close” to certain officials and opening credit lines to companies with unknown ownership structures are so opaque that the international financial services company Standard & Poor’s revised its outlook on Russia’s sovereign credit rating from “stable” to “negative” last week (www.newsru.com, 23 October). Corroborating this was Transparency International, which gave Russia its worst mark in eight years, so that in the Corruption Perception Index it now shares 147th place (out of 180) with Bangladesh, Kenya, and Syria (Nezavisimaya gazeta, October 24).

Medvedev quite possibly feels the need to add more substance to his anticorruption initiatives and provide some explanations for the apparent lack of results from the much-advertised interventions. Putin, however, cannot tolerate dissent from his junior partner, since any crack in the monolithic system of power could trigger an avalanche of desertions and revelations that would demonstrate that corruption is not a mere defect in his course of expanding state control over the economy but its core substance. His approval ratings may still remain high; but the social contract of “Putinism,” according to which the population enjoys the fruits of petro-prosperity while ignoring the shameless thievery of the ruling elite, is about to expire (www.gazeta.ru, October 22). The peculiar two-headed form of leadership was designed by the over-confident “tsar” for presiding over a permanent party of distributing tons of easy money; but it cannot function in the situation of escalating squabbles between elite clans and gathering social discontent. Cutting Medvedev down to size with his address was easy, but now Putin has to decide how much longer he can postpone the hard tasks of managing rather than explaining away the crisis that has transformed his pet projects into toxic assets.

Three of Baev’s points in particular echo my previous analyses: (a) “the spectacular increase in corruption schemes and channels in the emergency situation of siphoning off hard-currency reserves that still amount to half a trillion dollars”, (b) “any crack in the monolithic system of power could trigger an avalanche of desertions”, and (c) “the social contract of ‘Putinism,’ according to which the population enjoys the fruits of petro-prosperity while ignoring the shameless thievery of the ruling elite, is about to expire (www.gazeta.ru, October 22). The peculiar two-headed form of leadership was designed by the over-confident ‘tsar’ for presiding over a permanent party of distributing tons of easy money; but it cannot function in the situation of escalating squabbles between elite clans and gathering social discontent.”

In a nutshell: Baev portrays a brittle natural state with stability dependent on simultaneously redistributing wealth to favored and powerful interests while generating enough growth to pacify the larger populace that is vulnerable to collapse due to defections of the powerful when the rents run low.

The impetus for Baev’s piece is that Medvedev’s speech to the Duma scheduled for last week has been delayed indefinitely, with no explanation that passes the laugh test. It is passing strange that in the midst of an existential crisis, the President’s speech has been delayed. It certainly gives the lie to the air of confidence that the government is attempting to project.

Maybe Kevin Bacon can do a public service announcement to help them out.

Let’s start a campaign: Free Dmitri Medvedev!

One of the most insightful, but underutilized, observations in economics is Frank Knight’s distinction between risk and uncertainty. In Knight’s terms, “risk” relates to something that is unpredictable, but where the unpredictability that can be quantified, like mortality. It is possible to identify the states of the world, and determine the relevant probability distribution with some precision. “Uncertainty,” in contrast, refers to the unpredictable that is not quantifiable. One cannot identify even the possible states of the world, let alone quantify their probabilities.

The insight is largely ignored in modern economics because the dominant formal methodologies cannot readily handle the unquantifiable–so they ignore it. By definition, Knightian uncertainty is unquantifiable, so it is incompatible with the methodology that virtually all economists use. The closest formalism comes is probably the literature on robustness, but even that is a stretch.

In observing the financial crisis unfold, Knight’s distinction has often come to mind. Financial economists are used to dealing with risk, and have developed elegant tools to model and measure it. But “uncertainty” in the Knightian sense seems to be a much better description of financial markets at the present. Even the most sophisticated market observers and participants are at a loss to describe what could happen, let alone assign any realistic probability to those inchoate possibilities. We are out of the realm of experience, and dealing with a tightly connected system that no one understands completely. It is hard to imagine a more (Knightian) uncertain situation than that.

And most economists–yours truly included–are ill equipped to handle it.

For a brief, not-so-shining moment, Volkswagen became the largest company by market capitalization in the world. How, you might ask, in the face of a crashing car market, could that be possible? In a word: SQUEEZE.

Numerous hedge funds went short VW shares, only to find out to their dismay on Sunday that Porsche had acquired a far larger long position than anyone expected. The scramble to cover short positions caused the price to rise from about 300 Euros to 1275 Euros. Just like the crude oil episode a little over a month ago, this bears all the hallmarks of a squeeze.

Porsche claims no responsibility, and in a statement that echoes many others that manipulators have made over the years, blames the shorts: “It added that it ‘denies all responsibility for these market distortions and for the resulting risks to which the short sellers have exposed themselves.'” It further said, “Short sellers [are] responsible for extreme price movements in Volkswagen.”

Sorry, kameraden, but (a) you are the large long, and (b) such price movements occur only if the large long inefficiently restricts liquidations of its outstanding positions in the underlying and derivatives. Note that the price came down substantially–but not to their pre-squeeze levels–when the company announced it would sell 5 percent of VW shares, doubling the float in the stock. This indicates that the company’s liquidation decisions affect prices–that it is a price maker, not a price taker.

The German regulator, Bafin, is investigating. It will be interesting to see how this turns out.

A common theme in much reporting and commentary on the Russian financial crisis is that it represents the oligarchs’ comeuppance, and the opportunity for the Russian state to reverse the theft of state property in the 1990s. In this narrative, the oligarchs are thieves and rogues who stripped the state of its patrimony, and they deserve to lose everything–and worse. The state will use its funds to acquire stakes in the oligarchs’ firms, cutting them down to size, and in the end, restore a simulacrum of the old Soviet system. As Stratfor puts it, “having a system where Russian firms cannot tap foreign capital markets and are instead dependent on the state is precisely how the Soviet state maintained operational and political control. It might not be central planning per se, but it is not too far off.”

This prospect is highly satisfactory to many Russians, and not just in the corridors of power. It is quite popular throughout Russia because, quite simply, the oligarchs are very unpopular.

I will stipulate that the oligarchs are, with no exception that comes to mind, a pretty odious bunch. They indeed acquired their vast holdings by means foul and fouler. They profited while the state, and the nation, starved. They deserve no pity or sympathy.

But restoring the control of what was taken from the state to the state is hardly an improvement, and may be a step backwards. This is in part because those in the state who will benefit are not obviously less odious than the oligarchs. But even overlooking that, expanding state control will reduce Russian wealth and economic growth. More extensive and intrusive state control will feed corruption; encourage rent seeking at the expense of wealth creation; weaken incentives to innovate and invest; reduce competition; and all in all just ensure that the Russian economy remains in purgatory, at best.

One Russian government spokesman said that the state had no plans to nationalize the firms acquired, and would sell them when conditions were more favorable. This statement is not credible–it is, as Mary Poppins said, a pie crust promise, easily made and easily broken. Once in powerful hands, it will be very hard to pry them loose. And even if there is a formal “reprivatization” process, what is the likelihood that it will be transparent, equitable, or efficient? Small. What is the likelihood it will represent another opportunity to create a new set of oligarchs? Pretty high.

In Darkness at Dawn, David Satter claimed that Yeltsin’s young liberal economists were actually prisoners of their Soviet educations. They believed Marxist dogma about primitive capitalist accumulation, and that any transition to capitalism would inevitably entail the enrichment of those with the least scruples. But, in their view, the creation of a market state would eventually tame and discipline these unworthy acquirers. Regardless of the original disposition of property and property rights, efficiency would ensure that resources would soon flow to high value uses, and that the managers and owners best able to create value would end up owning and controlling them. (Thus, I guess, they simultaneously believed in Marxist dogma, and the Coase Theorem as a reasonable approximation of reality.) To them, anything was better than state ownership and control, and primitive capitalist accumulation was merely an unsavory but necessary transitional step to a modern economy.

It didn’t work out that way. Institutions matter, and Russian institutions did not–and do not–fully encourage and support wealth enhancing Coasian bargains. Instead, rent seeking, the lack of a rule of law, and weak property rights have prevented the realization of the liberals’ vision.

So, it is likely that the pendulum will swing back towards state dominance, which is perhaps better described as state oligarchism, rather than private oligarchism. This trend has been evident for almost exactly 5 years–Khodorkovsky was arrested 5 years and a couple of days ago–but the financial crisis is accelerating the process dramatically.

In essence, Russia is between the Devil of state control and the Beelzebub of oligarchic dominance. There have been steps towards a more “normal country” market system (particularly in consumer goods), but a more thoroughgoing transition of large swaths of the economy (namely the “strategic” sectors which account for a large fraction of output) is nowhere in prospect. The unjust and fantastical enrichment of a tiny minority is being reversed, but this will not contribute to a more moderate enrichment of most Russians. Indeed, given the inefficiency of state management and control, it may even have the opposite effect.

In an earlier post I surmised that behomoth hedge fund Citadel was playing balance-of-power politics, working with the banks and against the CME by supporting the upstart ELX futures exchange, and working with the CME and against the banks in a CDS clearing venture.   In each case, Citadel was allied against the incumbent, dominant player (CME in futures, and the banks in the CDS market).

It appears that Citadel has decided this is not a viable strategy, and that it can’t play both sides against the middle.   According to a Bloomberg story by Matt Leising (not yet online), Citadel has resigned its ELX board seat.   Though it will still retain an ownership stake, it will no longer promote the ELX venture.

Presumably the deciding factors were (a) Citadel’s assessment of the likely success of the two ventures, and (b) its estimate of the profit potential of each.   One inference is that Citadel decided that the CME clearing venture is likely to succeed, and potentially in a big way, and that ELX is a much more iffy proposition.

There is definitely a case to be made for both propositions.   Although I’ve identified some hurdles that CME must overcome to make the CDS clearing venture go, most of the reporting I’ve read suggests that the exchange has the inside track.

Overall, I think this is another signal that the banks’ dominance in derivatives has been eclipsed.   Not only are their stock prices low, but their political stock is low as well.   Citadel is a savvy player, and its choice is a lot more credible statement about the current landscape than anything that I, or any other observer, can put forward; they are putting their money on the table.

DR was quite critical of Nicholas Eberstadt’s objectivity in one of his comments on Human Capital. DR has a detailed rebuttal to demographic doomsaying at his blog, and I encourage those interested to take a look at that, and make up their own minds.

But Eberstadt is not alone. As if on cue, Paul Goble summarizes several articles from Russian sources quoting Russian experts’ gloomy demographic predictions:

The financial crisis in the Russian Federation has pushed up the already high rates of mortality from heart and circulatory diseases there to third world levels, according to medical experts. And that development combined with other trends likely makes the demographic future of Russia even bleaker than had been thought.

Yevgeny Chazov, one of Russia’s senior specialists on heart disease, told a Duma hearing that “as a result of the difficult psycho-social circumstances” and “stress” from “instability in the country, ” 1.3 million people – 56 percent of the total number of deaths there – now die from heart disease (www.newizv.ru/news/2008-10-28/100653/).

At the hearing, other experts pointed out that Russia now has a mortality rate – 14.6 per thousand per year – that puts it “in one rank with the countries of Central Africa,” a situation that means “one in every three” Russians will die before reaching pension age and that both the size of the workforce and the overall population of the country will continue to decline.
But if many speakers blamed the financial crisis or personal behavioral choices like smoking or alcohol consumption, one, Aleksandr Baranov, the vice president of the Academy of Medical Sciences, was prepared to blame the Russian government. Medical science knows “how to lower mortality,” he said, “but we haven’t received an order from the powers that be.”

In a survey of expert opinion on this subject in advance of the Duma hearing, the Moscow newspaper “Trud” concluded that “the demographic situation [in Russia] over the next few years will only get worse,” although it cautioned that no one should blame the financial crisis for falling birthrates (www.trud.ru/issue/article.php?id=200810242010802).

Sergey Sakharov, the deputy director of the Moscow Institute of Demography at the Higher School of Economics, said that the small positive gains in fertility over the last few years are going to slow or even be reversed soon. And Igor Beloborodov said that the situation will become “worse.”

The recent small improvement in the birthrate “is not connected with economic stimuli,” Kirill Danishevsky of the Open Health Institute said. And any decline will not be entirely the result of such stimuli in the opposite direction because decisions about having children are made over a longer period of time.

But neither he nor the other experts with whom “Trud” spoke were prepared to “exclude the influence of the [current financial and economic] crisis on fertility,” although all of them insisted that it was unlikely to be “decisive” in changing the basic downward trend lines observed over most of the last two decades.

There is one thing that could help improve both fertility and mortality rates, Danishevsky said. If Russians were to drink less as a result of the crisis, even cutting consumption by one liter of pure alcohol per year, that alone would reduce mortality by three to five percent, a more significant achievement than any the Russian government has had since Soviet times.

The one paragraph that stands out in my mind is this one:

But if many speakers blamed the financial crisis or personal behavioral choices like smoking or alcohol consumption, one, Aleksandr Baranov, the vice president of the Academy of Medical Sciences, was prepared to blame the Russian government. Medical science knows “how to lower mortality,” he said, “but we haven’t received an order from the powers that be.”

One can see the essential role of “the powers that be” in implementing public health measures to control communicable diseases (e.g., TB, HIV/AIDS). But for lifestyle diseases like heart disease, and those associated with smoking and alcohol consumption, beyond education the potential contribution of government is minimal. These are effectively diseases of personal choice, and people have to make different choices to reduce mortality from them. With respect to alcohol in particular, Russian experience with government intervention has usually been disastrous and counterproductive, (as, I would argue, has been the war on drugs in the US.) (As an aside, Gorbachev’s anti-alcohol campaign had little effect on alcohol consumption, mainly inducing substitution to far more dangerous forms of the stuff, and putting a major crimp in the state budget at the same time due to a fall in profits from state vodka sales. Anybody have ready access to data on the RF’s current revenues from alcohol sales and taxes?)

The waiting for a signal from on high is a telling cultural detail.

I should say that any attribution of mortality trends to the financial crisis at this time is highly speculative and premature. Hell, the crisis is a couple of months old, at best. Methinks that it is a convenient smokescreen behind which concerned demographers can deliver their bad news. These trends have been developing for years. Certainly the prospect of economic difficulty does not bode well for reversing these trends, and may worsen them, but they were widely recognized even during a period of substantial growth, and indeed were stubbornly persistent during that period.

But, another country heard from. And in this case, that country is the one in question. Can’t pin this one on the AEI.

* This is a reference to an unintentionally hilarious comment to Misery Loves Company. The initial comment from David accuses me of being bought-and-paid-for by a cabal of Russophobes (including demonic oil companies). My old buddy Dave then accuses me of lying after I responded to his first comment, then after my subsequent reply relents and concedes that I might be a “Long wolf.” Whatever that is. Is English not your first language, David, or are you just another living testament to American public education?

Ambrose Evans-Pritchard has a fascinating article in today’s Telegraph. It is fascinating on many levels.

For one, it helps explain why European banks have been battered even worse than American ones. European banks invested in made-in-America subprime (which suggests that Americans are not uniquely culpable for that problem), but they also plunged far greater sums into emerging market investments, all of which are plummeting in value. The travails of European banks, and the prospects of worse to come, also helps explain the dramatic weakening of the Euro, the pound, and the Swiss franc.

Although US subprime has attracted most of the attention, because it cratered first, it is clearly not the only source of toxicity in bank balance sheets. It is becoming increasingly evident that low interest rates, attributable in part to the Asian savings glut and partially to liberal US monetary policy (less so European directly, but in an open economy Europeans didn’t have complete control over their interest rates) that encouraged yield shopping in a big way, and yield shopping means “add risk” in any language.

For another, the article also has some interesting tidbits about Russia. To wit:

Russia too is in the eye of the storm, despite its energy wealth – or because of it. The cost of insuring Russian sovereign debt through credit default swaps (CDS) surged to 1,200 basis points last week, higher than Iceland’s debt before Götterdammerung struck Reykjavik.

The markets no longer believe that the spending structure of the Russian state is viable as oil threatens to plunge below $60 a barrel. The foreign debt of the oligarchs ($530bn) has surpassed the country’s foreign reserves. Some $47bn has to be repaid over the next two months.

As Michel pointed out in a comment to another post, the heavy indebtedness of the oligarchs presents the Russian government with several unpalatable choices (though DR does not find them as bad.) Bailing the oligarchs out of their foreign denominated debt would put a large dent in, and perhaps exhaust, the massive reserves that Russia has so assiduously accumulated in the past several years. Since most of the debt is collateralized by shares in companies, many of which are Russian (though, again per DR, some are in the US and Europe), oligarchic default would transfer large ownership positions in “strategic” Russian businesses to despised foreigners. Or, the Russian government could expropriate the oligarchs/nationalize their businesses, and hang the Western lenders out to dry. By so doing, they would keep their “crown jewels” out of the hands of foreigners (and, conveniently, in the control of the siloviki in the government), but (a) this would turn Russia into a pariah that would have acute problems accessing capital markets in the future, and (b) destroy value by concentrating even more control over enterprises in state hands, which distorts incentives and encourages rent seeking.

My guess is that in the short to medium term, the government will try to buy time and dole out financial support to the oligarchs in the hope that things will turn around. Only if the country’s reserves are depleted too rapidly, or the reserves fall to an uncomfortably low level, will the government contemplate something more extreme. And if it comes to that, I would wager that Russia would choose “pariah” over ceding substantial stakes in “strategic” businesses–even minority stakes–to foreigners. The latter option is too much at odds with the entire rationale for Putinism, and would drive the nationalist elements in Russia around the bend, thereby jeopardizing Putin’s domestic support. Given the choice between stickin’ it to The Man (i.e., foreigners) and living without foreign capital (who needs those bloodsucking bastards anyways?), and being labeled a traitor to the motherland, I think it’s pretty clear which way Putin would jump. But maybe he’ll get lucky, things will turn around, the price of oil will recover (along with the world economy) and Putin will never have to make that hard choice. That’s why buying time and spending the reserves makes sense in the near term.

But, suffice it to say, that the worm has truly turned in the last three months. During that short time, Russia has gone from globe straddling giant (in its own mind, anyways) to a gambler looking to survive by drawing an inside straight. Not that things are rosy in the USA, but as bad as things are here, I’d rather play our hand than Putin’s.

Those who follow Russia know that its dreams of becoming a colossus are built on demographic feet of clay. Nicholas Eberstadt has the details in today’s NYT.

Human capital is a far more important, enduring, and reliable basis for economic growth than oil and minerals. Death and disease certainly deplete a nation’s stock of human capital, but there are other interesting issues here as well. I have commented before on the presentism not just of Putin (whom I called “A Man in a Hurry” in a post some time back) but of Russians at large. I have also mentioned the emphasis on consumption as opposed to investment and saving. Now, the available data focus primarily on expenditures on consumption and saving, but people make all sorts of life choices that don’t really show up in the statistics that affect their stocks of human capital. I would conjecture that a consumption oriented culture is not focused on accumulating human capital.

The causation can go both ways, but there also has to be a connection between the demographic factors that Eberstadt depressingly documents and consumption, saving, and human capital investment choices. People–men in particular–who have a high risk of dying early, and a small chance of living well into retirement years, have a small incentive to save, or to invest in human capital. It must also be noted, though, that health and longevity are the result of choices as well. People choose to engage in unhealthy lifestyles, to smoke, to overeat, to imbibe too much vodka. Indeed, health is a form of human capital, where capital is conceived of broadly as anything that requires a sacrifice of consumption today and receive in return a stream of benefits (higher consumption) in the future–health is capital, and there is a choice component to health. People who make those life-shortening choices are deliberately opting not to accumulate human capital; they would prefer the immediate gratification of consuming those things, rather than living longer and consuming more in the future. Viewing demography as the product of a constellation of choices, some personal, some political, it is evident that Russians have overwhelmingly voted for the present over the future.

Seen this way, Russia’s demographic crisis and many of the more mundane choices of present over future that Russians make are of a piece. They are both symptoms of a tendency to discount the future very, very heavily. Why? That is a weighty question, certainly beyond easy analysis. It is effectively a matter of preferences, and economists typically take those as given. Someone more religious than I might attribute it to a spiritual deficit–but that only pushes the question back a step, to: Why is there a spiritual deficit? As someone historically and economically oriented, I am inclined to conjecture that the tendency to discount the future reflects (a) the historical experience of the Russian people, who have suffered cataclysm after cataclysm, and (b) the insecurity of property and life in a system that lacks a rule of law, has a weak civil society and institutions, and which is vulnerable to the predations of an overawing and virtually unlimited state.

But these are just conjectures, and given that we have only one data point and myriad potential competing explanations, no definitive answer is in prospect. It does seem to me, however, that the presentism of Russia and Russians, which is so evident in the decisions of both the powerful and the ordinary, is a central fact that anyone studying Russia, or charged with making policy towards it, or doing business with it, must always keep in mind. It likely contributes to aggressiveness and impulsiveness in government policy at home and abroad, and an incentive to deal aggressively and dishonestly in business (as the accumulation and protection of reputation is effectively an investment). It also tends to contribute to instability in political, business, and human relationships. And, perhaps more depressingly, it is self-reinforcing, an equilibrium outcome that is difficult to exit. So, in the end, when thinking about how Russia will evolve in the future, it is important to remember that Russians are focused on the present.