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09.11.2008

October 30, 2008 (the date of publication in Russian)

Vladimir Sidorovich

AN ALTERNATIVE TO PYRAMIDS. Part 1

The crisis as the starting point of a new curve of redistribution

The new financial crisis has erupted exactly a decade after the notorious default of 1998. Emerging in the United States from the collapse of the mortgage market and related derivative financial instruments, it spread across the globe with a speed, proportional to development of globalization, and eventually cracked upon the Russian stock market. Spokesmen of governments and financial corporations lament over flaws in the system of risk management in investment banks, along with shortcomings of national and international regulation of financial markets. In Russia, severity of the implications of the crisis is explained with dependence of the stock market from capitals of non-residents, excessive liabilities of economic subjects at foreign markets, insufficiency of liquidity in the domestic banking system, along with the military conflict in Georgia and other political factors.

The abovementioned factors are really significant – but superficial. Gliding along the surface, the analyst fails to apprehend the internal background of the unfolding process, and therefore, to find adequate means of dealing with relevant problems and elaborate mechanisms helping to mitigate potential disturbances.

 

PRODUCTION OF INEQUALITY

First of all, it has to be understood what is the current financial market and which role it plays. As the financial market is a too broad definition, including the banking system, shares, bonds, derivatives, we'll restrict our research with the stock market, as this segment is the critical sphere that catalyzes crises.

The present financial market is a most powerful instrument of redistributing financial resources from the majority to the minority of the population and thence of increasing production of inequality. Its predicated functions Ц mobilization of resources for a more efficient investment in production, as well as insuring (hedging) of financial risks Ц has been long substituted, the major role shifting to speculative enrichment by means of "financial technologies". By now, the balance of useful and harmful properties of the financial market is not a matter of discussion, as its useful properties don't compensate the costs; moreover, their share is steadily contracting.

This evolution of the financial market is natural, as the purpose of the market's subject if reduced to maximization of profit and speed of its extraction Ц a purpose typical for any usurer and shroff. It is quite logical that the process of generating new value, including the industrial element (to produce in order to sell most profitably), typical for industrial capitalism, is replaced with a different logic: to generate a most efficient financial scheme for deriving maximum profit. Why produce, if modern technologies enable players to derive income from purely financial manipulations without any relation to production and non-financial services?

In fact, redistribution by means of the financial market has been organized on a principle of a pyramid, though of an implicit, covert character. This system may be imagined as a network of small brooks converging into an affluent and turbulent stream. Money, quietly flowing out of pockets of billions people, converge into a new Golden Horde.

This pyramid is relatively steadfast due to the following distinctive features:

1. Involvement of a huge number of people in a global dimension, creating an effect of a herd ("everybody is doing that"), fueled by new participants. The routine, everyday flow of market information, reports of quotations being as regular as weather forecast, create an illusion of naturality, and thus the financial market itself performs as a phenomenon of nature.

2. The still remaining connections to real economy Ц particularly, the share of investments, attracted in the process of primary floating of stocks, is directed into industrial assets Ц not only create an impression of "a real mission" but saturates its with vigor.

3. Unlike a banal financial pyramid, in which redistribution is a simple flow of money from the bottom to the top, the financial market has got some regulating institutions. These ingredients impart a more sophisticated and respectable appearance to European markets.

What do we Russians have in common with this pyramid?

The fact that the number of holders of shares and units of investment funds does not exceed 1% of the Russian population is used as a proof of insignificance of the market disturbances for the Russian population. This view is somewhat superficial. It is true that in a static situation, at a given moment, most of Russian citizens don't care a rap of rise or fall of particular stocks. In the perspective, the financial market displays an unpleasant peculiarity: being a playground for a small layer of people, it robs also the majority which is ostensibly out of the game.

This robbery is expressed in inflation and devaluation of savings, insufficiency of support of the social sphere, soaring prices of real estates etc. In 1998, in 2000 (the crisis of E-economy), as well as nowadays, we encounter the same phenomenon: financial growth with no real substantiation, derived only from involvement of new players and uncovered monetary emission, incurring economic ruin not only on the players.

In case the monthly rate of income of an investor is higher that the growth of GDP, productivity of labor and the monetary mass taken altogether, who pays for this feast? This person has not produced anything: he just bought a paper and resold it. His success is in fact paid by those whose income increases not so rapidly. Globalization makes this process international.

While the pyramid attracts more and more players, we face an illusion of everyone's prosperity. But when the crisis arrives, only a narrow team of major players is on the velvet. This circle includes owners and top managers of hedge funds and investment companies, as well as their key clients with skills of manipulating the market, possessing the dominating volumes of accumulated money along with most convenient access to information that enables to make decisions more operatively than other players. According to J. Diamond, they "are highly motivated with the perspectives of quick and guaranteed incomes, and they distribute losses among a larger number of individuals".

This process of redistribution is permanent. The crisis is in fact the instance of fixation of the inequality's proportions, and at the same time the starting point of a new curve of redistribution. Persons possessing free monetary resources during the crisis purchase the devaluated assets, and thus new proportions are being shaped.

The mechanism of the new crisis is persuasively exposed by FBC Corp. in its analytical report "Stock markets" the limits of growth and the depth of collapse": "The global financial crisis of year 2008 is a result of a global re-capitalization of markets and not of the mortgage crisis that in fact played only the role of catalyst". In Russia, "the global financial crisis is only an additional powerful impetus for the collapse of the national stock market. Its fundamental reasons are: overcapitalization of the Russian stock market and deterioration of macroeconomic indices". In other words, capitalization of markets has too far decoupled from the soil of reality, and this made the crisis inevitable.

In this regard, the crisis is not a crisis in the medical meaning, suggesting an acute disease, but on the contrary, a short period of normality after a lengthy bacchanalia of unsubstantiated growth, "an orgy of predatory instincts, ugly greed of gain and speculation (Nikolay Berdyaev). Unfortunately, hangover is experienced also by those who were not involved in the orgy, watching it only from outside.

The view that the financial market does not influence the real sector of economy, that "the sphere of speculative capitals is so autonomous that its convulsions don't leave any traces" (Jean Baudrillard) is incorrect. Watching the process in a dynamic, we come to understand that though real economy almost does not influence the financial sphere, the reverse impact exists: the financial market permanently imposes a negative effect on real economy, as well as on the society generally. It distracts resources from production (though by definition it has to be contrariwise), destimulates productive activity (as it can't be more lucrative than speculation), and generates destructive forms of economic behavior, based on the principle of a nomad or a gambler. We speak about a permanent negative influence exerted not only during the crisis.

"Liberalization of financial markets arouses instincts, typical for casino players, and increases probability of crises. Unlike casino, national financial markets are closely connected with the external world, and the losses are paid by the real sector of the economy", writes ex-Treasury Secretary Larry Summers.

 

NECESSITY OF STRATEGIC VISION

Anti-crisis measures, announced by the Russian Government, are today only technical, being focused only on the treatment of the acute stage of disease (to subdue fever). Though the crisis had been approaching for several months and did not take the Government by surprise, strategic preventive measures were not undertaken. At present, the Russian Government is reproducing measures earlier undertaken by other European states. This is being explained with necessity of rapid reaction, as well as with a narrow arsenal of applicable remedies.

In this array of measures, the decision to allocate 500bln rubles for support of the stock market looks most doubtful. Is it motivated with the Government's responsibility before the participants of "global IPOs" who now regard themselves as "defrauded investors"? In any case, disbursement of this money is going to speed up inflation that is already high. The expected stabilizing effect is not obvious.

Meanwhile, what we require today is strategic vision and the ensuing new principles of regulation of the financial markets. Russia requires these new principles for following reasons:

Firstly, despite the remarkable dismantlement of the welfare state (social state in German terminology) in the West during the recent 3-4 decades, its tradition remains strong, especially in Northern Europe. We witness a gradual dilution of the middle class and increase of social polarization, but this process is sluggish; it encounters cultural resistance. The institutions of the social state are deeply rooted in the society and are not going to be momentarily sacrificed to the financial crisis. This resistance, to a certain extent, enables to compensate the redistributive effects of the financial market.

Secondly, the theory of extinction of nation states in the era of globalization has not fully been implemented in practice. Western states still possess levers instrumental for regulating markets, and to change Ц though in a restricted scale Ц the vector of economic development. Their fiscal systems are perfectly functioning, maintaining the capability to deter the increasing inequality.

Thirdly, the industrial sector of Western nations supplies domestic markets with vital goods (except energy), including agricultural production. Despite expansion of the non-productive sphere in GDP and outsourcing of industries, European countries still dispose the technological base essential for production of primary commodities at the place.

Due to the abovementioned circumstances, Western nations have had a possibility to allow themselves financial speculation, as the economic base, amortizing the effects of financial markets, is still functioning. Still, speculation developed to an extent that the Chancellor of Germany now regards as a menace to the whole existing social pattern.

Russia is in a worse situation, as the social state exists here as a mere combination of words in the Constitution. Domestic industrial and agricultural production does not meet the demands of the internal market: Russia depends on imports. State management is stronger than it was in the 1990s but still weaker than in European countries. In fact, the power of the state is measured not only with the density of traffic policemen per 1 square kilometer but also with other parameters Ц particularly, the capability to guarantee implementation of laws on its territory. Despite ostensible paternalism, conservatism and social rhetoric, the Russian state is ultraliberal. Citizens are actually plunged into conditions of natural selection, being helpless before the nomads of financial capital.

Thus, Russians are much less protected from destructive effects of the financial market and the implications of the financial crisis, as the state does not have any reserves permitting to safely play speculative games. The oil and gas cushion and the stabilization fund can serve only as a thin interlay that isn't sufficient for a long while.

(To be continued)

*Vladimir A. Sidorovich, Ph.D. (Econ.), is a postgraduate of the Moscow State University and a professional banker with experience of work in MMKB Bank (Moscow), Commerzbank (Germany, Russia), Bank of Moscow, KMB Bank (Moscow). He also had extensive training in BMW AG (Munich, 1992), ABN-Amro Bank (Wien, 1993), Dresdner Bank AG (Frankfurt, 2002), EBRD (London, 2002). Currently, Mr. Sidorovich is a managing partner of «Sidorovich & Partners» advisory services, a BoD member of the Far Eastern Bank and a member of the Independent Directors Association (Moscow).


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