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"Do not spit in the Well, for later you might want to drink"


Dr. Pyotr Johannevich van de Waal-Palms

The global economy has been brought about through innovation, technology and deregulation. To the extent the government prints more Rubles than the equivalent of the hard currencies earned on exports, it will lower the exchange rate of the Ruble. In effect the government makes itself a forced partner of anyone with Rubles, by printing some for which there was no corresponding production of goods. By laws and policies it transfer this money from the poor to the rich. Printing Rubles is the same thing as collecting a tax. But it is a tax on possession of money not production of money and is therefore parasitical.

If a country runs a current account deficit it needs to finance it with a capital account "surplus" (i.e. inflow). If it has a current account surplus, it must have a corresponding capital account "deficit" (i.e. outflow). Comparing 1979-81 with 1985-88 West Germany's capital balance moved from an inflow of $8 billion to an outflow of $40 billion. Japan's from an inflow of $5 billion to an outflow of $75 billion, and America's from an outflow of $2 billion to an inflow of $129 billion. But this yardstick is hardly of any use: it is inaccurate and misleading.

A balance of payments yardstick for capital flows gives a misleading impression because they show net rather then gross flows of capital. In 1980 total world bank cross border and foreign currency lending was $324 billion. By 1991 it was $7.5 trillion. The combined GDP (Gross Domestic Product) of the 24 industrial countries in 1980 was $7.6 trillion; in 1991 it was $17.1 trillion. So during the past ten years bank lending has risen from 4% of GDP (Gross Domestic Product) of these 24 nations to 44%. From 1970 to 1988 the ownership of American bonds by foreigners increased from 7% to 17% and for Germany from 5% to 34%.

Turnover in foreign exchange is now $900 billion each day. There are now 35,000 trans-national companies with 147,000 foreign affiliates. Finance has become totally global. History shows that the countries whose governments do not involve themselves in business and have no regulations about business get the most investment. Russian budget "investments" are not investments at all but subsidies. They are no substitute for real capital. Elimination of regulations about business develop economies. Currency risk is the greatest deterrent to investment. In an international economic system of global integration, differences between interest rates precisely match the expected changes in the relevant exchange rates. If a one year dollar assets yields 5% and a one year Ruble asset yields 600%, investors must expect the dollar to appreciate 595% against the Ruble over the next 12 months.

It is more difficult to steer economies with Monetary policy and fiscal policy when capital flows freely in a global economy. Financial interdependence has neutered government economic policy makers. Monetarists believe that all you have to do to control inflation is control the supply of money. The "quantity equation" of Monetarists says that the supply of money in circulation multiplied by the number of times it turns over in the economy each year must equal the price level, multiplied by the amount of output produced. Under these conditions slowing the growth of money will slow the growth of demand. The events of the 1980's have obliged us to disregard this theory. It has however been accepted that output is driven by supply-side factors and not by demand. For monetarism to succeed it must be possible for the government to control the supply of money and there must be a stable relationship between the amount of money and the amount of demand in the economy. Due to financial innovation and the expansion of global finance neither of these conditions was met in the big industrial economies in the 1980's. Raising interest rates no longer controls the money supply.

Domestic interest rate policy is undermined in a global economy. Higher interest rates increase exchange rates. If governments chose to limit exchange rate fluctuation they cannot increase interest rates. The truth is that there is no longer any such thing as money in the historic sense. Charles Goodhart proclaimed the following law. "Any statistical regularity breaks down once pressure is placed upon it for control purposes". Governments change the way an economy works when they try to act upon it (control it). In a time of rapid innovation, expanding cross-border flows of capital, diminishing control through regulation, and the creation of new borders, the opportunities for statistical regularities to break down in unforeseen ways are multiplied many times over. Loosening fiscal policy (budget deficits) together with tightening monetary policies ( currency exchange controls, higher taxes, business regulation) create high interest rates. Russian policy has driven $260 billion in flight capital out of Russia in the past three years negating the effect of all foreign investment by 200%.

International capital has played a big role in supplying the needs of the American government. America's account balance worsened from a surplus of $1 billion in 1980 to a deficit of $160 billion in 1987.- the mirror image of the country's inflows of capital. If capital controls had been in place, America would have had to finance its fiscal deficit domestically. That would have required interests rates to rise significantly. If the deficit had been financed by printing money as Russia has done in 1991-1993, rising inflation would have resulted. Without open borders to capital and a free market economy without government regulation of business, interests rates, or exchange rates, the choice facing Russia is the same. Since Russia has limited borrowing credit abroad it cannot be irresponsible in spending or it will inflate the Ruble. That is a useful reminder. The ability to borrow money can be harmful to an economy. Russia can follow the example of Baltic currencies or those of The Ukraine.

The greatest opportunity for Russian economic recovery is to eliminate all rules and regulations and allow business the opportunity to expand GDP (Gross Domestic Product) and thereby pay more to the government at lower rates of taxation. This will permit the government to spend more of this revenue on social services and invest in expansion of future production by providing credit to industry at affordable interest rates. To survive through the transition period it will be necessary to substitute "compensatory finance" for printing of currency. It is also necessary to repay debt by transferring ownership of industry.

The market is self disciplining with punishment (bankruptcy) for failure. This is much preferred over government regulation by fiscal policy. Open capital markets lets business men pass a vote of no confidence in the government by moving money abroad. Such exercise of discipline by the market over government is the best self correcting economic policy. The threat of capital flight is a powerful sanction on the government and assures efficiency. It vetos unaffordable programs and establishes priorities. It delays purchases until the purchase price can be earned by producing it. Is the market vicious, frightening and unfair? So far those Governments who live by it have survived and reached the highest standard of social services for their citizens. America, which has increased it capital inflow to compensate for its trade imbalance, is surviving on trust that it will not start the printing presses and inflate its currency thereby settling its debts by inflating them away. America continues to attract capital because its creditors trust it not to inflate. Will Russia inflate? Currency appreciation continues to be a reward that investors expect to receive from dollar assets at low interest rates. Does Russia have the courage to join the group of market economy nations. Do its leaders have the vision to take the people there by refusing to finance through printing money and rising inflation? That only Russia can answer. Thus far the answer has been wrong. The ruble has dropped to R3200 =$1.00 a decline of more than 30% in the past two months.

The availability of overseas financing has altered the character of Russia's fiscal policy options. Budget-making is no longer simple. International flows of capital respond to changes in monetary policy and complicate the task of economic management by effecting the exchange rate. International flows of capital also respond to fiscal policy. The more open the Russian economy becomes the more sensitive it will be to changes in interest and exchange rates. Unsurprisingly the result depends upon the government attitude towards exchange rates. Russian policy makers have to choose between monetary policy (strong under floating rates, ineffective under fixed) or fiscal policy (weak under floating rates, strong under fixed). Preferred monetary policy, chosen w with domestic inflation in mind most likely will not conform to the preferred exchange rate, chosen with international competitiveness in mind. Often the two will conflict and one will have to go. Frequently the exchange rate must go to where the interest rate sends it. The notion that the exchange rate can be used to preserve competitiveness, even as monetary policy is fighting inflation, belongs to an earlier era. - to a time when current account imbalances, not interest-rate differentials, drove currencies . The expansion of global finance has tied money policy and exchange-rate policy inextricably together. So much so that shifts in competitiveness (as expressed in changes in current account balances) now have no detectable effect on exchange rates at a all. It will be some time before economic policy and the new global market for capital learn to get along.

A drive towards more tightly regulated domestic markets, if attempted, would fail because financial markets have knitted themselves together and it will take more than the wit of governments to separate them. The country that tries to regulate more tightly will find that it has delivered its financial industry into the hands of foreign competition. Governments must not themselves become a source of financial instability. Budget deficits must be kept small. Central banks must be allowed to go about their work unmolested.

Mechanisms must be created to assure the government that it will receive its fair share of profits in the form of a reasonable tax. Russian industry must have complete freedom to use its profits to invest in machinery and production and grow and to go bankrupt if it cannot earn a profit.

So far Russia has never tried a radical reform. It has not even tried a reform. What it has done is try to support its existence by taxing assets rather than income and transferring money from the poor to the rich and powerful. It is suffocating Russian business before it can even get started. The result will be the death of the goose that could lay the golden egg. The existing production of Russia is simply inadequate to give the total population a decent living. Production must be increased. Nothing can be gained by sharing what is left. Give a man a fish and he is hungry again the next day. Teach him how to fish and he will support himself. Industry must be left sufficient capital to support itself. If it is not, Government will drag down industry and they will sink together. For production, investment is needed. For investment economic freedom to produce and retain a fair portion of the results of labor is necessary. There is no other way. Government investments are not investments. They are subsidies, obtained from producers and given to non-producers. It cannot last. Such rules will keep capital far away from Russia. Look at Taiwan and what it has accomplished in 40 years without any natural resources. The greatest resource of Russia is not what is in the ground but what is in its people. The people will rescue the government if the government has the good sense to permit it.

Industry must make its own decision completely free. Government does not have competence in Economic affairs other than to collect a fair tax. Flight capital must be avoided through good accounting. In exchange for freedom, industry must guarantee the government a fair amount of taxes on its profits. Ownership of profits belongs to industry and capital not to government. Industry has sovereign rights of private property over its profits and capital. Government rights are only for the fair amount of tax on such profits. Industries which earn no profits should not have to pay any taxes.

Until such civilized norms are observed export license auctions will remain bribes to government for exporting flight capital, decent housing will be provided only to foreigners, and international investors will include in their expectation of return and assessment of risks, the cost of arbitrary blocks on their bank accounts, withdrawal of work permits, 600% increases in their printing costs, retroactive cancelation of tax incentives and imposition of back taxes for two years. This will be added to the c cost of their contracts during negotiations. Why is Russian labor worth more money outside Russia's borders then inside Russia?

Why are Russians successful, optimistic, positive, creative, competitive, and even joyous outside their borders, where they miss their home land. They are the same people in both places. Why can't their energies be freed where they are without a brain drain to the motherland? Why do Westerners, who are successful outside Russia fail inside Russia. They are the same. Could it be that at something within the borders is the problem? If it is not the Russian people then what and who is it that is causing so much difficulty?

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