Streetwise Professor

September 18, 2008

Cocaine Blues, Revisited

Filed under: Economics,Energy,Politics,Russia — The Professor @ 2:39 am

About a year ago, in “Cocaine [Oil] Blues,” I wrote:

The thing about cocaine is that what goes up, comes down with crash. After that shot, you feel invincible, but the comedown is brutal and depressing. That’s what happened to Willy Lee, and what’s likely to happen to Putin-or his successor, if there is one-when oil prices come down, as they inevitably will.

That day may have arrived. Even though oil prices are still higher than they were at the time I wrote that piece, they are well off their historical highs. Moreover, developments in the world financial markets have combined with the decline in the oil price (and exacerbated the decline) to shake the Russian financial system to its foundations. The equity market is in freefall–indeed, trading was halted today in a typically shortsighted attempt to kill the messenger. But the equity market, and the capital market more generally, is not the cornerstone of the Russian financial system. Russian finance is bank-centric. Those banks have always been shaky, and they are showing signs of acute strain in the midst of capital outflows and a flight to liquidity. Major Russian corporations are also highly leveraged, and tap external markets for credit. The credit crisis will constrain their ability to continue to finance their operations.

Sitting here in the US one can hardly crow about the state of the banking system, but as bad as things are here in the US, they are marginally worse in Europe, and substantially worse in Russia.

As oil prices skyrocketed, and billions flowed into Kremlin coffers, and the economy recovered from its 1990s disasters, Putin et all–and the Russian public–wildly exaggerated the nation’s economic strength and economic independence from the rest of the world. Like Willie Lee after his shot of cocaine, Putin (and Russians generally) felt invincible.

But the strength was extremely dependent on a factor largely beyond Kremlin control–the world price of oil. And that factor was–and is–extremely dependent on world economic activity. What’s more, Russia is dependent on external capital flows. The credit crisis strikes at both sources of dependence. Hence, when New York or London feels a chill, Russia gets pneumonia.

This dependence has been, as I have written, exacerbated by self-inflicted wounds–Mechel, BP-TNK, and, most importantly, Georgia. Russia therefore faces a perfect storm of internal and external factors that will seriously challenge Putin’s grandiose ambitions.

The question becomes–Can Putinism withstand the strain?

Recall that the Putinist economy is a “natural state” that uses resource-based rents to buy peace (or, perhaps, merely peaceful coexistence) among rival factions of siloviki. The sustainability of this system is questionable if these rents decline substantially. Moreover, using the cartel analogy I have advanced in the past, systemic crises can raise the discount rates of the rival clans, which can also undermine their incentives to maintain the uneasy cooperative equilibrium, and instead grab while the grabbing is good. Thus, at the level of the “elites” (a polite expression that in this context refers to Chekists who exercise control over the state’s coercive powers), the financial crisis corrodes the monetary glue that binds rival gangs in an uneasy peace. The crisis therefore dramatically increases the odds of an outbreak of conflict among rival clans.

But the problem is not limited to the prospect of interclan warfare alone. One of Putin’s accomplishments has been to reverse the despond of the 90s, and replace it with extremely high social and popular expectations of a prosperous future. In part, this is due to the fact that by comparison to the 90s, anything looks great. In part, it is due to the fact that the economy has without a doubt improved–in large part due to external factors for which Putin et al have been more than willing to claim credit. In part, it is due to the drumbeat of propaganda emanating from the government and its media lackeys. But whatever their source, these very expectations pose a great threat to Putin. If they are disappointed–and the credit crisis and the knock-on effects on Russia’s banking and capital markets dramatically raises the risks of disappointment–Putin’s (and Medvedev’s) popular support is at risk. Bank failures, or difficulties in obtaining credit on now accustomed terms, or a spike in inflation resulting from (a) a decline in the ruble, and (b) massive injections of liquidity in an attempt to prop up the banking sector, could all bring back memories of the 90s, thereby striking at the very rationale for Putinism.

Thus, economic weakening poses both elite and popular challenges to Putinism. Internal and external events over the last months have increased substantially the likelihood of such a weakening.

It may be premature to posit that Russia’s “Black Tuesday” and associated events represent an existential crisis for Putinism. But maybe not. Putin has essentially entered into a Hobbesian bargain with the Russian people. In exchange for a restoration of public order, and ending a war of all-against-all (as many people view the 90s), Putin demanded unchallenged authority and the perquisites of power. A struggle among the elites to protect their own shares of a shrinking pie would give the lie to the image of order that is essential to the maintenance of the system. Indeed, it could well spark a return to actual violence, either among the clans, or directed at any manifestation of popular unrest, that would call into question the viability of the Hobbesian bargain.

As I have written before, the Putinist system is extremely brittle. If it breaks, it will shatter. In a largely non-idealogical system held together by rents and a promise of order and improved living standards, financial shocks are the primary thing that can cause the structure to collapse.

What might transpire in the coming days and months? There is a distinct risk of greater instability. I definitely expect a pronounced ramping up of anti-Western, and anti-American, vitriol–as hard as that is to imagine given the rhetoric already emanating from Russia. But Putin et al have clearly made attacks against the West a major part of their political defense at home. I also anticipate an intensification of domestic oppression, and a clampdown on the few remaining independent outlets for public opinion–including especially the internet. Atomizing the domestic opposition and uniting the country against a common enemy are tried-and-true tools of control in Putin’s Russia.

There is also an air of unreality, and denial, surrounding the Russian leadership today. Medvedev gives anodyne “there’s nothing to worry about” pronouncements; Putin announces large increases in defense spending (at the same time the resources to fund such increases are declining and are likely to decline further.)

Even if Russia muddles through the current situation, there are still reasons to doubt the benefits of Putinism. For those whose horizons are defined by the Soviet period or the 1990s, Russian economic accomplishments of the Putin era do indeed seem nearly miraculous. Those, however, are very low standards indeed. What Putin has essentially created is an economic and social purgatory–certainly an improvement on hell, but hardly the best outcome that can be envisioned, and one that it is difficult to escape for something better. The prospects for moving beyond the purgatory of the natural state to something more dynamic, modern, and self-sustaining are poor.

To use a financial metaphor (which seems appropriate under the circumstances), to me Russia is like a short options position. Limited upside. Large–and potentially unlimited–downside. As North et al point out, the natural state is self-limiting; it must be so to survive, as it cannot withstand the uncontrolled development of competing sources of power and wealth. But, at the same time, it is vulnerable to collapse in the face of increased uncertainty or declines in the rents that hold the system together. We may stand at the cusp of the latter outcome.

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  1. It risks being quite the crash if oil prices go down and stay down. Even if they do up, Russia has been investing little to actually maintain (let alone increase) production. How much of GAZPROM’s $60 billion was actually invested into bringing new fields into production as opposed to buying television and radio stations and doing the dirty economic deeds dictated by Putin & Co. All the stats show that Russian production is falling in the oil and gas sector in spite of the years and billions they had available to invest when times were good. Where will they find the money to do it now when prices are falling and Russia has been discredited as a safe “haven” for investors?

    Also, much of the boom in Russia was helped by the availability of credit. Going from virtually nonexistent in 2000, Russian consumers borrowed hundreds of billions to buy consumer goods, apartments, cars, trips to Turkey, and just about anything else. What will be the impact of tighter credit? Presumably, stores will be selling less and the Russian consumer who hoped to buy goods with credit will be frustrated when they find out that it is much harder to get credit. This will certainly change perceptions in Russia.

    Comment by Michel — September 18, 2008 @ 8:56 pm

  2. I should be more careful when posting. I overlooked some typos. It should be GAZPROM’s $60 billion DEBT. 🙂

    Comment by Michel — September 18, 2008 @ 9:57 pm

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