Living Off of a Bubble Economy

Martin Wolf, an economic columnist for the Financial Times, recently wondered why Russia was touched by the 2008 financial crisis at all and asserted that it is overcoming the downturn better than its neighbors.

Meanwhile, 2008 is being repeated. This time, the raging crisis involving Greece, Spain and other highly indebted European nations should have passed Russia by as well, since the Russian government is virtually debt-free. Yet, Russia fared worse than most countries in Europe. Its stocks lost from 20 percent to 25 percent in six weeks, and the ruble dipped even against the euro. Why?

Over the past decade, Russia has been one of the main beneficiaries of excess liquidity flooding world financial markets. After the 1997-98 financial meltdown in Asia and Russia, monetary authorities around the world began pumping money into the global financial system. The flow accelerated after the implosion of the Internet market in 2000 and the Sept. 11, 2001, terrorist attacks in the United States. Cheap, plentiful liquidity created an economic boom during the middle years of the decade, but it also caused numerous distortions on financial markets and in the world economy.

Most important, excess liquidity distorted prices. Under normal conditions, price is a very sophisticated mechanism, telling market participants precisely how much to supply and what to buy. Price is the magic “invisible hand” that Adam Smith so admired for its ability to balance markets.

Too much money confused market participants. It misled bankers, who began lending to risky borrowers at extremely low interest rates. It misled U.S. families, who were convinced that they could afford bigger, more expensive homes. It misled Chinese economic planners, who built too much manufacturing capacity in order to supply vast consumer demand in Western Europe and North America.

Eventually, excesses are always eliminated when too many market players make too many wrong decisions and financial bubbles develop and then burst. A correction was set into motion when U.S. housing prices began to fall in the second half of 2007 and gathered momentum a year later, after investment bank Lehman Brothers went bust. Governments and central banks responded by adding even more money — trillions of dollars worth. This slowed the process, but now highly indebted governments are starting to see their debt bubbles deflate. If the bubble in U.S. Treasuries eventually bursts, this would have disastrous consequences for the world economic and financial system.

Russia has been living off a bubble economy. Magically, it went from an economic basket case after the 1998 default to seemingly boundless riches a decade later thanks to a bubble in commodity prices. A variety of secondary bubbles also developed as Russian companies borrowed abroad and the government spent lavishly on higher pensions, the Sochi Olympics and other white elephants. But when the ongoing global liquidity correction runs its course, Russia may find itself back in the 1990s.

The Greek debt crisis foreshadows another danger: social unrest. Just as in the financial crisis of 2008, Russia may also be a weak link in terms of social stability. Western Europe may be facing strikes and even riots, but protesters there also have the ballot box. In Russia, however, there are fewer outlets for social anger. Over the past decade, its democracy became less representative and government institutions less efficient. Its bureaucrats are corrupt and inept, and the people hate them. This could spell disaster in any serious economic hardship.