the most vehement atheists in Europe - but this is because they adopted
other deities. They have always been zealous, intellectual fanatics.
One of my Czech friends calls many periods in his nation's history
"intellectual terrorism". The swings some people made lately from being
youthful communists to being vengeful ultra-capitalists are indeed
breathtaking. Personality cults are supplanted only by fanatic
ideologies, which are replaced only by religious zeal. This, of course,
does not tend to enhance the realpolitik instincts of the nation.
Czechs have always been a few years too early. They had their own
reformation long before Luther. They had the Spring of 68 long before
Gorbachev. Every such intellectual transition was followed by a Jacobin
disposal and by purges of whole classes and elites. These "new
religion-personality cult-purges" cycles were not absent from the
Velvet Revolution.
Simply, the EU got frightened. Excessive zeal can give anyone - let
alone the Brussels amphibian bureaucrats - cold feet. Dates are being
pushed back. Commitments hushed or rehashed. Now the Czechs "enjoy" the
worst of both worlds: they are being treated as a colony and their date
of entry is ceaselessly postponed.
This should and could have been different. The Czechs should not have
shown any enthusiasm or anxiety. These are bad negotiating tactics.
They should have negotiated with the EU as consumers (markets) do with
producers elsewhere in the world. They should have extracted at least a
commitment regarding the date of accession and detailed timetables. And
they should have kept these timetables.
(Article published December 14, 1998 in "The New Presence")
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New Paradigms, Old Cycles
New paradigms die hard. It took a looming global recession to convince
wild-eyed optimists that old cycles are more reliable guides than new
paradigms.
Business cycles - from the smallest to the biggest - go through seven
phases. Centuries of cumulative economic experience allow us to
identify these stages more accurately than ever before.
An economic cycle invariably starts with inflation. The previous cycle
having ended - and the new one just began - the economic environment is
as uncertain as can be. The fundamental component is the scarcity of
goods and services (following recession or deflation) and the
maladapted money supply. Too much money chases fewer commodities. The
general price level rises. But this constant, ubiquitous, all pervasive
rise (known as "inflation") is also the result of mass psychology.
Households and firms compensate for the growing uncertainty (=growing
risk) by raising prices. They have no idea what should the appropriate
or optimal equilibrium price level be. Market signals are garbled by
psychological noise. Everyone is trying to stay ahead of perceived
economic threats and instabilities by raising the risk premiums that
they demand from their clients. Consumers, on the other hand, are
willing to pay more today because they are convinced that the price
trend is unidirectional and irreversible: up. The psychological
underpinnings and bearings of inflation have been studied deeply in the
last few decades. It is the source of the uncertainty that remained
obscure. My hypothesis is that the end of every economic cycle fosters
this panicky uncertainty, which is monetarily reflected as inflation.
In more technical terms, inflation is a market pathology, a market
failure.
Inflation disguises bad economic performance of firms and of the
economy as a whole. "Paper" profits make up for operational losses. The
incentives to innovate, modernize, and enhance productivity suffer.
Economic yardsticks and benchmarks get distorted and do not allow for
meaningful analysis of the performance of the economy. Inflation leads
to technological and economic stagnation. Plants do not modernize, the
financial aspects of the firm's operations are emphasized, the
industrial and operational aspects de-emphasized and neglected.
Economies are seized by the pathological economic condition known as
"stagflation" - zero or negative growth, coupled with inflation. A
sense of urgency and crisis sets in and clears the path towards the
next, second phase.
In an effort to overcome the pernicious effects of inflation,
governments liberalize, deregulate and open their economies to
competition. Firms innovate and streamline. Efficiency, productivity
and competitiveness are the buzzwords of this phase. As trade barriers
fall, cross border capital flows (=investment) increase, productivity
gains and new products are introduced - the upward price spiral is
halted and contained. The same money buys better products (more
reliable, more functions, more powerful). The same wages generate more
products. This is technological deflation. It is beneficial to the
economy in that it frees economic resources and encourages their
efficient allocation. Real incomes rise and generate increased demand
and production.
Inevitably, technical deflation leads to a restraint in the general
price level. Increased consumption (both public and private) coupled
with moderate asset price inflation prevents an outright monetary
deflation (=a downward spiral in the general price level). Inflation is
kept to sustainable levels. This phase is known as "disinflation". It
is a transitory phase. The transition from hyperinflation or high
inflation to a supportable level of inflation is a matter of one or two
decades. This period is bound to be shortened by the revolutions in
information, communications and transportation technologies. In fact,
the whole cycle is hastened due to the more rapid dissemination of
information. It is the availability and accessibility of information,
which determines the values of important parameters such as the
equilibrium general price level and other parameters of expectations
(such as equity prices). The more information is available more readily
- the more efficient the markets and the shorter the cycles. This
enhances the false perception of instability inherent in modern
markets. But speed does not necessarily a imply lack of stability. On
the contrary, the faster and more violent the adjustments in the market
mechanism - the more efficient it is.
The psychological well-being and assurance brought on by disinflation
generate demand for assets, especially yielding assets (such as real
estate or financial assets). The more certain the future value of
streams of income, the more open the economic environment, the shorter
the economic cycle, the more frequent and rapid the economic
interactions - the more valuable assets become. Assets are mainly
stores of expectations regarding future values. An assets bubble is
created when the current value (=price) of money is low and the future
value of money is certain and likely to grow through stable or
decreasing prices. Stock exchanges, real estate, and financial
transactions - all balloon out of proportion in a kind of irrational
exuberance.
All bubbles burst in the end - and so do these assets bubbles. This is
the fifth phase. It is crucial because it signifies the termination of
the bull part of the cycle. The prices of assets collapse
precipitously. There are no buyers - only sellers. Firms find it
impossible to raise money because their obligations (commercial paper
and bonds) are rendered valueless. A credit crunch ensues. Investment
halts.
The collapse of assets bubbles generates asset price deflation. The
psychological counterpart of this deflation is the disappearance of the
"wealth effect" and its replacement by a "thrift effect". This
influences consumption, inventories, sales, employment and other
important angles of the real economy. If not countered by monetary and
fiscal means - a lowering of interest rates, a fiscal Keynesian
stimulus, an increase in money supply targets - a monetary deflation
might set in. Admittedly, a full-fledged deflation is rare. More
frequent are a recession, a slump, a credit crunch, a slowdown, a
growth recession and other less exotic variants. It is also possible to
have differentiated or discriminatory deflation. This is a deflation in
certain sectors of the economy or in certain territories of the globe -
but not in others. In any case, a monetary deflation is a monstrous,
venomous economic beast. Due to reversed expectations (that prices will
continue to go down), people postpone their consumption and spending.
Real interest rates skyrocket because in an environment of negative
inflation, even a zero interest rate is high in real terms. Investment
and production slump - inventories shoot up, further depressing prices.
The decline in output is accompanied by widespread bankruptcies and by
a steep increase in unemployment. The real value of debt increases.
Coupled with declining prices of assets, it leads to bank failures as a
result of debts gone sour. It is a self-perpetuating state of affairs
and it calls for the implementation of the seventh and last phase of
the cycle.
This is the phase of reflation. The market failure, at this stage, is
so pervasive that all the self-balancing and allocation mechanisms are
rendered dysfunctional. State intervention is needed in order to
restart the economy. An injection of money through a fiscal stimulus, a
monetary expansion, a lowering of interest rates, firm support of the
financial system, tax and other incentives to consume and to import.
Unfortunately, all these goals are best achieved by engaging in
warfare. It is often the case: a convenient war reflates the economy,
re-ignites the economic engine, generates employment, and increases
consumption, innovation and modernization. But with or without war -
people sense the demise of an old cycle and the imminent birth of a new
one, fraught with uncertainty and ignorance. They rush to buy things.
Because the economy is just recovering from deflation - there aren't
usually many things to buy. A lot of money chasing few goods - this is
a recipe for inflation. Back to phase one.
But the various phases of the cycle are not only affected by psychology
- they affect it. During periods of inflation people are willing to
take on risk. The risk of inflation is clear to them and the only
compensation is through higher yields (returns, profits) on financial
instruments. Yet, higher returns inevitably and invariably imply higher
risks. Thus, people are forced to offset or mitigate one type of risk
(inflation) with another (credit or investment risk). Paradoxically, an
inflationary period is a period of certainty. Inflation is certain.
People tend to develop an ideological type of economics. Based on the
underlying and undeniable certainty of ever-worsening conditions, the
intellectual elite and decision-makers resort to peremptory, radical,
rigid and sometimes coercive solutions backed by an ideology disguised
as "scientific knowledge". Communism is a prime example, of course -
but so is the "Free Marketry" variant of capitalism, as practised by
the IMF and by central bankers.
Deflation, on the other hand, is usually a much shorter period. People
do not expect it to last. They fully expect it to be followed by
inflation - they just do not know when. Thus, its nature is more
transitory. Assured of low prices and preoccupied with economic
survival - people become strongly risk averse. While in times of
inflation people are seeking to protect the value of their money - in
times of deflation people are in pursuit of sheer livelihood. A
dangerous "stability" sets in. People invest in land, cash and, the
more daring, in bonds. Banks do the same. In such times, ideologies are
the first victims. They are replaced by philosophies and worldviews.
People become much more pragmatic. They look to the possible rather
than to the ideal. Communism is replaced by Socialism, Capitalism
replaces Free Marketry. Perhaps this is the only good outcome of
deflation.
(Article published November 9, 1998 in "The New Presence")
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Lessons in Transition
Question: What have been the most successful approaches to attracting
direct foreign investments: offering prospective investors tax breaks
and similar benefits, or improving the overall investment climate of
the country?
Answer: Empirical research has demonstrated that investors are not
lured by tax breaks and monetary or fiscal investment incentives. They
will take advantage of existing schemes (and ask for more, pitting one
country against another). But these will never be the determining
factors in their decision-making. They are much more likely to be
swayed by the level of protection of property rights, degree of
corruption, transparency, state of the physical infrastructure,
education and knowledge of foreign languages and "mission critical
skills", geographical position and proximity to markets and culture and
mentality.
Question: What have been successful techniques for countries to improve
their previously negative investment image?
Answer: The politicians of the country need to be seen to be
transparently, non-corruptly encouraging business, liberalizing and
protecting the property rights of investors. One real, transparent (for
instance through international tender) privatisation; one case where
the government supported a foreigner against a local; one politician
severely punished for corruption and nepotism; one fearless news medium
- change a country's image.
Question: Should there be restrictions on repatriation of foreign
investment capital (such restrictions could prevent an investment
panic, but at the same time they negatively affect investor's
confidence)?
Answer: Short term and long term capital flows are two disparate
phenomena with very little in common. The former is speculative and
technical in nature and has very little to do with fundamental
realities. The latter is investment oriented and committed to the
increasing of the welfare and wealth of its new domicile. It is,
therefore, wrong to talk about "global capital flows". There are
investments (including even long term portfolio investments and venture
capital) - and there is speculative, "hot" money. While "hot money" is
very useful as a lubricant on the wheels of liquid capital markets in
rich countries - it can be destructive in less liquid, immature
economies or in economies in transition. The two phenomena should be
accorded a different treatment. While long-term capital flows should be
completely liberalized, encouraged and welcomed - the short term, "hot
money" type should be controlled and even discouraged. The introduction
of fiscally oriented capital controls (as Chile has implemented) is one
possibility. The less attractive Malaysian model springs to mind. It is
less attractive because it penalizes both the short term and the
long-term financial players. But it is clear that an important and
integral part of the new International Financial Architecture MUST be
the control of speculative money in pursuit of ever-higher yields.
There is nothing inherently wrong with high yields - but the capital
markets provide yields connected to economic depression and to price
collapses through the mechanism of short selling and through the usage
of certain derivatives. This aspect of things must be neutered or at
least countered.
Question: What approach has been most useful in best serving the needs
of small businesses: through private business support firms, business
associations, or by government agencies?
Answer: It depends where. In Israel (until the beginning of the 90s),
South Korea and Japan (until 1997) - the state provided the necessary
direction and support. In the USA - the private sector invented its own
enormously successful support structures (such as venture capital
funds). The right approach depends on the characteristics of the
country in question: how entrepreneurial are its citizens, how
accessible are credits and microcredits to SMEs, how benign are the
bankruptcy laws (which always reflect a social ethos), how good is its
physical infrastructure, how educated are its citizens and so on.
Question: How might collective action problems among numerous and
dispersed small and medium entrepreneurs best be dealt with?
Answer: It is a strange question to ask in the age of cross-Atlantic
transportation, telecommunication and computer networks (such as the
Internet). Geographical dispersion is absolutely irrelevant. The
problem is in the diverging self-interests of the various players. The
more numerous they are, the more niche-orientated, the smaller - the
lesser the common denominator. A proof of this fragmentation is the
declining power of cartels - trade unions, on the one hand and business
trusts, monopolies and cartels, on the other hand. The question is not
whether this can be overcome but whether it SHOULD be overcome. Such
diversity of interests is the lifeblood of the modern market economy,
which is based on conflicts and disagreements as much as it is based on
the ability to ultimately compromise and reach a consensus. What needs
to be done centrally is public relations and education. People,
politicians, big corporations need to be taught the value and
advantages of small business, of entrepreneurship and intrapreneurship.
And new ways to support this sector need to be constantly devised.
Question: How might access of small business to start-up capital and
other resources best be facilitated?
Answer: The traditional banks all over the world failed at maintaining
the balancing act between risk and reward. The result was a mega shift
to the capital markets. Stock exchanges for trading the shares of small
and technology companies sprang all over the world (NASDAQ in the USA,
the former USM in London, the Neuemarkt in Germany and so on).
Investment and venture capital funds became the second most important
source quantitatively. They not only funded budding entrepreneurs but
also coached them and saw them through the excruciating and dangerous
research and development phases. But these are rich world solutions. An
important development is the invention of "third world solutions" such
as microcredits granted to the agrarian or textile sectors, mainly to
women and which involve the whole community.
Question: Women start one-third of new businesses in the region: now
can this contribution to economic growth be further stimulated?
Answer: By providing them with the conditions to work and exercise
their entrepreneurial skills. By establishing day care centres for
their children. By providing microcredits (women have proven to be
inordinately reliable borrowers). By giving them tax credits. By
allowing or encouraging flexitime or part time work or work from home.
By recognizing the home as the domicile of business (especially through
the appropriate tax laws). By equalizing their legal rights and their
pay. By protecting them from sexual or gender harassment.
(Article written on October 15, 1999 and published November 22, 1999
in "Central Europe Review" volume 1, issue 22)
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Lucky Russia
As early as August 17th, a few minutes following the devaluation, the
financial markets predicted that the Rouble would stabilize around
18-20 Roubles to the US dollar. This was the price quoted for CME
forward Rouble contracts. Moreover, not everyone think that
hyperinflation is imminent. Simply, there is not enough purchasing
power to generate this kind of surge in prices.
Russia is lucky. I am not being cute: this crisis could not have come
at a more opportune time. Russians have witnessed (if not actively
enjoyed) the advantages of a consumer capitalist economy. For one
thing, most of them have some kind of private property and the
abundance of all types of products together with the elimination of
queues and shortages served to provide a foretaste of the "capitalist
heaven". They are not likely to go back, politically or economically.
That capitalism is not well entrenched is a blessing in no disguise:
this crisis does not deprive people sufficiently to foster a
revolution. Social unrest, a dramatic rise in crime rates, more crony
capitalism and other malignant forms of "get rich quick" schemes -
perhaps. But not another revolution.
Russia and Russians are prone to dramatic extremes. Russia is simply
going through a crisis which will ultimately engulf all of Eastern,
Central and Southern Europe and, more generally, all the protective,
etatist economies. From Macedonia to the Czech Republic, from
Kazakhstan to China, from Slovenia to Bulgaria - all are likely to
experience a similar shock. This is because none has really reformed.
Under the banner of "capitalism" a small, corrupt elite of oligarchs
and politicians robbed the assets of the state. Industry is still
protected against outside competition, tax collection is a farce, the
banking system a shambles, Western handouts the only pillar of the
economy. This cannot and will not go on. The invisible hand of the
market will devalue overvalued currencies, force industry to
restructure, force the banking system to amalgamate, force inept and
corrupt politicians out. The Day of Judgement is here. Russia is lucky
to go through all this now - because it will be uniquely positioned, as
a result.
The Russian banking system will be forced to restructure. Hundreds of
banks will go insolvent and bankrupt. The rest will consolidate. But
this will only result in the formation of a few "bad banks". The next
stages will involve the formation of healthy retail activities, where
none exist today. Banks will begin to compete for savings. They will
diversify their portfolio and, as a result, their exposure (risk) will
diminish. Then they will have to invest this money to generate the kind
of returns that will attract the savers. They will not risk another
asset bubble. They will not invest in brokerage operations, speculate,
or bet against the Rouble anymore. Their future profits will be the
result of investments in real assets: industry, the services sector,
new and small businesses. These are very good news: the banks have been
taught a lesson they will not easily forget. It is: paper profits and
paper assets are on paper only. Here today, gone tomorrow.
A devalued Rouble will enhance the competitiveness of the Russian
industrial and commodity production sectors. Rouble inflation will not
fully reflect the devaluation for a long time. This difference will
allow Russian manufacturers and commodity producers to compete
vigorously.
Russia was long subjected to the quack "medical experiments" of the
IMF. It was led down the path of deflation, which the IMF has plunged
half the world into. It needed to reflate urgently. It could not have
"chosen" a better way to do so. The devaluation will reflate the
economy. It is equivalent to the infusion of new blood to a body
dilapidated by endless austerity and economic bloodletting.
It might sound outlandish - but Russia is showing the way to other
countries in the Third World as it has so often done in the past. It,
in effect, has acted against the IMF dictates and by devaluing its
currency it has readopted the path of John Maynard Keynes. It was about
time.
(Article published August, 1998 in "The New Presence"
and October 28, 1998 in "Argumenti i fakti")
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Russian Roulette