New democracies that inherit a financial crisis are especially susceptible to a complete hyperinflationary collapse
Russia is in such a deep state of crisis that its new democracy and social stability remain at risk. The situation could unravel in a spiral of self-reinforcing destructive behaviors: criminality, regional separatism, tax evasion, flight from the currency. To overcome these risks, the Russian government should embark on a policy of rapid stabilization, backstopped by large-scale western assistance. That is the contention of Jeffrey Sachs, in a paper presented at the sixth Annual Conference on Development Economics.[1]
The shock therapy approach to stabilization---an abrupt tightening of monetary conditions, an early pegging of the exchange rate, and large-scale international aid to support the stabilization---is desirable because it offers the most realistic chance of avoiding a political catastrophe. Contrary to much wishful thinking, attempts at gradual stabilization have failed in most countries, and are likely to fail in Russia as well, mainly because high inflation tends to be dynamically unstable, planting the seeds of even greater inflation in the future. But tough stabilization without large-scale foreign financial support is also likely to fail, if high unemployment and inadequate social support produce political instability.
Russia was within reach of stabilization in the first half of 1992. Along with the enormous fall in budgetary revenues as a percentage of GNP, there was a comparable fall in government spending as a percentage of GNP. In the first quarter, net Russian central bank credit to the general government was actually negative, at -2.3% of GDP, and during the first half of the year, the overall credits were a mere 3.0% of GDP. The overall money supply grew an average of 8% a month during February to May, due mostly to reductions of excess reserves in the banking system rather than to increases in net credit from the central bank. By August, inflation rates had declined to 9% a month, which proved to be the low point during 1992 and 1993.
Russia restricted central bank credits in the first half of 1992, and could have moved progressively to more complete stabilization with the provision of external support. The western perception was the opposite: that the budget deficit, on the order of 25% of GDP, was fueling a high inflation (in December 1992, the IMF recorded a 1992 "enlarged deficit" of 24.9% of GDP, though domestic financing of just 2.7% of GDP). On the basis of this enlarged deficit---enlarged by including a part of the imports financed by bilateral western credits---the IMF delayed disbursements of aid and the introduction of a ruble stabilization fund. Ironically, the western export credits were the cause of the widespread perception that stabilization was out of reach! A crucial opportunity to move to complete stabilization was lost.
The notion that Russia was heading relentlessly toward hyper-inflation in the second half of 1992 because of large budget deficits or deficit financing of loss-making state enterprises is simply a misunderstanding, on both the Russian and the western side, or so says Sachs. With a separate Russian currency and more foreign financing, it would have been possible to reduce money growth sharply while maintaining the same net credit transfers to the state enterprise sector.
If stabilization were simply a process of cutting budget deficits and cheap credits, missed opportunities in 1992 and 1993 could be made up in 1994. Unfortunately, missed opportunities give time for forces inimical to stabilization to grow. The most obvious such force is political. The lack of success in stabilization in 1992 and 1993 contributed to the political reversals of the reformers in the December 1993 parliamentary elections and therefore to much higher risks of hyperinflation in 1994.
Tax collections continue to shrink in 1994, both because of tax evasion and because of increased resistance, formal and informal, to tax payments by the regions.
The sharp decline in state spending in recent years has weakened the state in several ways. Public support and legitimacy have been undermined. The desirability of enterprises remaining in the "official" system has been reduced. Criminality appears to be on the increase. And the region's fear of retribution from central authorities for tax withholding also has probably been undermined.
Another area of a self-reinforcing trend toward higher inflation is the flight from the ruble. Velocity has been rising steadily. The ruble supply (M2) is now a mere 11% of annual GDP, much lower than average for countries at Russia's level of per capita income. With the continuing shrinkage of the inflation tax base, Russia requires a rising level of inflation just to collect the same underlying level of real inflation taxation.
So far, Russia has avoided a complete collapse of central authority, but it is difficult to judge how weakened the central state really is at this point. The adoption of the new constitution in December 1993 has tended to strengthen the political capacity of the central government. Nonetheless, as Russia's own history has amply shown, the formal guarantees of a constitution might be unable to withstand the onslaught of real economic and social forces of disarray.
Economic crises are always characterized by instability, complexity, divided authority, and society in turmoil. Stabilization occurs seemingly despite the odds, precisely because it can be started, if not sustained, by a small group of policymakers, backed by international support. The question is rather one of sustainability: the chief tactic is to use early successes to bolster later political authority in support of more fundamental reforms.
The concerns raised here apply more generally to weak states in acute financial crisis. The current methods of delivering aid are typically too slow and too oblivious of the risks of a "contagion" of state collapse. Exceptions occur, but usually when one of the leading nations takes on the effort of support mostly by itself (for example, the United States in relation to Mexico's stabilization). More than half the countries of the former Soviet Union were in hyperinflation in 1993. None received the kind of financial support, or even advice, from the international community that was needed under the circumstances. Throughout the world, weak, newly democratic states are grappling with an inheritance of high indebtedness and failing public institutions. These countries can overcome their bitter inheritance, but only if the world community responds with urgency and support.