Streetwise Professor

The contrast between the monetary situations in Russia and the US is striking.  In the US, money supply has exploded, but demand for money has increased further, leading to a decline in the “velocity” of money.  This graph of US has to be seen to be believed (and perhaps not even then).  As a result of the decline in velocity, inflation has actually abated, and by some measures (e.g., the CPI) we are experiencing a deflation.  

In Russia, in contrast, base money has been declining (about 10 percent in January), but velocity has been increasing, leading to an acceleration in inflation.  

This difference demonstrates that the “financial crisis” is not all the same everywhere.  Its effect and symptoms differ among nations.

In the US, individuals and firms have responded to the increase in the risk in the financial system by wanting to reduce their exposure to private liabilities.  These include, inter alia, the liabilities of banks (e.g., banks don’t want to lend to other banks), corporate debt, and individual debt (e.g., mortgages).  Instead, they want to shift their wealth into liabilities of the US government, including base money, deposits guaranteed by the federal government, and Treasury securities.  Avoiding the mistakes of the Great Depression, the Federal Reserve has accommodated this spike in the demand for its paper by flooding the system with liquidity.  Despite this tsunami of liquidity creation, inflation has abated and the dollar strengthened because the Fed was responding to a dramatic increase in demand, rather than unilaterally raising supply with no corresponding demand increase.  (For now, I should emphasize.  I am very nervous about the medium-to-longer term prospects for inflation and the dollar.)

In Russia something similar has happened.  A loss of confidence in banks led depositors to  reduce dramatically their demand for bank liabilities.  The Russian central bank accommodated this demand for liquidity in a sensible way, by injecting massive amounts of liquidity into the system much like its cousin, the Fed.  Failure to do so would have wrecked the banking system.  This is one of the policy choices that Sergei Guriev praises in the article I linked to earlier.  

But here’s the difference–and the similarity.  In the US, people wanted to substitute holdings of US government liabilities for private liabilities, hence the decline in velocity.  In Russia, people haven’t wanted to substitute holdings of Russian government liabilities for private bank liabilities and corporate liabilities.  Instead, like Americans, they’ve wanted to substitute holdings of US government liabilities for their holdings of Russian bank and corporate and government liabilities.  This requires selling rubles and buying dollars and dollar assets.

Hence, the decline in the ruble.  The Russian central bank has accommodated some of this demand to substitute dollars (and euros) for ruble liabilities (both private and government, e.g., currency) by selling dollars from reserves (contributing to the decline in the ruble money supply).  

So, what Russians and Americans quite clearly agree on is that they want to increase their holdings of US government liabilities, and reduce their holdings of other liabilities.  But that has very different implications, very different costs, and imposes very different constraints on policy makers, for the US and Russia.

By not floating completely, the RCB is encouraging behavior that contributes to inflation, and other inefficient practices observed of late.  In particular, anticipating future declines in the ruble, it is sensible for Russians to convert their ruble holdings into goods as well as dollars.  Hence, the increase in velocity (people spending their rubles faster) and the spurt in inflation observed in January.  The return of barter is another manifestation of the growing unwillingness of Russians to hold their government’s liabilities, specifically its currency.  

This is why, as bad as the policy headaches are in the US, they pale in comparison to those bedeviling Russian policymakers.  In the US, it has been possible to accommodate individuals’ desired changes in their asset holdings by printing something these individuals want (for now, anyways).  In Russia, that isn’t an option.  In the US, private liabilities are unattractive, but dollar government liabilities are (again, for now).  In Russia, both private and government liabilities are unattractive.  We can print money without immediate adverse consequence because people want to hold it (kicking down the road the problem of how to sop it all up down the road when–or is it if?–normalcy returns.)  Russia can’t because people don’t.  It can either accommodate the changed demands of Russians by drawing down on reserves, further devaluing the ruble, or jacking up interest rates.  Is death an option?  Always, and it’s not obviously dominated by these other choices.  

In brief, Russia faces a policy constraint that the US has been able to avoid so far; the unwillingness of its citizens (or anybody else) to hold its government liabilities.  Russians want liquidity, but not in the form of rubles.  The supplying of liquidity to the banks has kept them in business, but has led to the transformation of bank liabilities into dollars and euros, not rubles or Russian government debt.  This translates into a decline in the ruble, and a spike in inflation.  No way around it.  None.  

This is politically charged for Russia.  Past collapses of the ruble, and episodes of inflation, have shaken governments.  The causes of Tsarist collapse in 1917 are many, but certainly one was the explosion in inflation, and the ham-handed response to it (especially price controls that destroyed the market for grain, leading to shortages in the cities where the February Revolution broke out.)  

If you don’t have anything to sell that anybody wants to buy, you are in trouble.  Right now, the markets for oil and rubles are in the dumper (the latter in part because of the former).  Which is probably why Alexi Kudrin is green with envy for Timothy Geithner and Ben Bernanke.  There aren’t many people about whom the same can be said.