Dances with the Dragon
No. 1 2009 January/March
Olga Butorina

Olga Butorina is a Doctor of Economics, professor, head of the European Integration Department, Advisor to the Director of the MGIMO University of the Russian Foreign Ministry, and a member of the Board of Advisors of Russia in Global Affairs.

The current crisis is often seen as a match to the Great
Depression of the 1930s.  Yet there is a hope that it would
not evolve into a humanitarian disaster. The standard of living in
the crisis-hit countries is much higher now than 80 years ago, and
they are not facing the threat of all-out unemployment or poverty.
The world’s GDP is not going to fall by one quarter within the next
few years, and hungry people will not be marching to Washington or
other capitals, while inhuman dance marathons, such as the one in
Sydney Pollack’s movie  is likely to forever remain a

The two crises are similar in that they both began in the United
States, with financial upheavals quickly engulfing the
manufacturing sector and a majority of regions of the world. The
key common characteristic is the breakdown of market mechanisms. In
the 1930s, it was caused by the first wave of globalization.
Production technologies changed dramatically at the turn of the
20th century: there was a breakthrough in the development of
transport and communications, and transnational oil companies were
established and gained a firm footing. As a result, certain
national and colonial economies were drawn into the world economic
system. The collapse of the New York Stock Exchange on October 24,
1929 put an end to an erratic market. It turned out that market
forces could not run the world economy without an active
participation by the state.

The current restructuring of the market relations was triggered
by the completion of the global economy formation. In the past two
decades, we witnessed processes that have changed the world. The
rapid development of information technologies, the breakup of the
bipolar political system, the spreading of capitalism to all
regions of the world, the liberalization of capital flows and the
fast growth of financial markets have lent a new quality to the
world economy. The interdependence of certain countries, regions,
markets and processes has increased dramatically. The imbalances in
trade and financial flows have grown to global proportions.

At present, the state – as in the times of the Great Depression
– has to re-define its relations with the market: figuratively
speaking, it has to tame the dragon first, and then dance with it,
keeping time with the situation on the world market. The task would
be difficult, because each country, region and group of countries
will have to learn and perform a dance of their own.


The events that have led to the ongoing crisis are surprisingly
reminiscent of the situation in the 1920s. In 1925-1929, stock
prices on the New York Exchange grew almost three-fold. Millions of
Americans speculated on the exchange to gain more profit. In the
first years of the 21st century, not only stock prices grew
rapidly, but also real estate’s. The record-low interest rates
stepped up competition among banks. To attract clients, the banks
eased the requirements to borrowers. They took little interest in
the borrowers’ real incomes in the hope that the prices of houses
they had as collateral would keep growing and that loans would
easily be redeemed with higher prices. In other words, banks and
their clients were playing a big financial pyramid. As in 1929,
there came a moment when it collapsed.

It is opportune to describe the present crisis as
over-consumption, rather than overproduction. Excessive
consumption, not justified by the real economic situation, became
the last resort for the markets of the United States and a number
of European countries to delay an impending system transformation.
Mass consumption involved everybody: the population, companies,
banks and the state. The average state debt of the U.S. and the 27
EU countries stood at around 60 percent of the GDP in the recent
years. In 2006, the debt of U.S. and British families reached 150
percent of their real income, while in Germany and many other EU
countries it made up 80 to 100 percent. Clearly, no family can live
without buying food and medicines and paying for electricity for 18
months in a row. At present, U.S. families deduct 18 percent from
their net income for debt payments, on the average. Thus, the
150-percent liability can be redeemed in eight or ten years. Until
very recently, ordinary members of the consumer society would never
think of tightening their belts for such a long period.

Many came to believe that the global economy was able to produce
virtual money to buy real goods and services. Stock indices grew by
leaps and bounds in the past few years. The rising stocks were a
welcome security for credits. But this implied that one kind of
obligation – shares and bonds – made the groundwork for other
obligations, i.e. bank loans. The emission of virtual money by
private companies and banks turned into a separate economic
activity, quite profitable and practically unaccountable to
anybody. New financial instruments played the key role in that
process; the consequences of their use were not clear to the state
and consumers, and even its originators were unable to fully
realize the implications.

The long worldwide increase in the prices of real estate, gold,
stocks and exchange commodities was, in fact, a warped form of
world inflation. The bloated U.S. balance of payments deficit and
the constant decrease in the dollar rate from 2002 against major
currencies made investors turn to alternative assets. With the
statistically low inflation in developed countries (2 to 3 percent
a year), inflationary pressures began to affect the spheres which
monetary authorities were unable to control – the commodity and
stock floors. As a result, the hidden inflation, together with
money supply, made a classic crisis tandem.

Information flows are another reason behind the malfunctions of
market mechanisms, or, rather, their changed role in the production
of material values. In the past 10 to 15 years, information has
become as important a factor of production as labor, land and
capital. But whereas labor, land and monetary relations are
regulated by extensive legislation shaped over centuries, relations
in the sphere of information are still at the puberty stage of wild
capitalism. Newspapers and magazines, along with advertising and
rating agencies, directly influence the demand, supply and prices
of products on the market – from simple commodities to complex
financial instruments. Yet none of them bears responsibility
commensurate to the deviations of money flows they create.

Many have an impression that the era of monetarism, associated
with the names of Ronald Reagan and Margaret Thatcher, is fading
into the past, to be replaced by a modified version of Keynesian
economics. Indeed, speeches by world leaders and declarations by
international economic organizations are infused with Keynesian

The nationalization of debts, massive injections into the
banking sector, increased controlling functions by the state –
these are all Keynesian tools. At the same time, it would be
incorrect to assert that Keynesian objectives – full employment and
stimulation of domestic demand – have been made the

The new economic policy (regardless of the name it will be given
in the future) should be able to resolve two key tasks: restore the
normal functioning of market mechanisms and return to the state the
niche it has lost in the economic system. At first glance, this
mission has inherent contradictions, as it appears to be
neo-classical and Keynesian at the same time. Yet it is based on
common sense and the current situation.

That market mechanisms are imbalanced can be seen with the naked
eye. Dramatic fluctuations in the prices of stocks, real estate,
fuel and food show that the market has ceased to be the key measure
to gauge the socially justified cost of this or that product. If
that is so, the allocating function of the market (dealing with
rational distribution of resources) is faulty as well: capital is
invested in speculative transactions rather than in the
manufacturing sector. This hampers the realization of yet another
objective of the market – facilitating technological process and
increasing labor productivity.

The breakdown of adequate supply-demand interaction is
particularly noticeable on the money market, or the market of
inter-bank loans. When U.S. banks cut the volume of current credits
to European partner banks in September 2008, due to non-payments at
home, a liquidity crisis hit Europe. There was an acute shortage of
dollars for daily trade and conversion transactions. In this
situation, each commercial bank decided to hold back its cash and
stopped extending loans to other partner banks even at high
interest rates. To save the market from collapsing and solvent
banks from bankruptcy, European governments and the European
Central Bank took unprecedented bailout measures.

The panic in the banking sector subsided, but the money market
has not been re-launched since. Large commercial banks with
sufficient supply of cash only give loans to privileged clients. An
overwhelming majority of other European banks can only borrow from
national central banks, which makes such transactions less
convenient and more expensive. The most popular instrument –
unsecured one-day loans – has been withdrawn from the market. Basic
reference rates (LIBOR, EURIBOR, EONIA), a starting point in
calculating the cost of credits, have become, in effect, a theory.
Their use has decreased due to the drastic decrease in the volume
of transactions.

The deformation of market mechanisms is fraught with yet another
danger. If operators stop relaying signals to each other – and
therefore do not contribute to market pricing, the state
monetary-credit policy stops working. For example, in order to pull
the economy from recession, central banks normally lower the
refinancing rate. It is assumed that intermediaries, i.e.
commercial banks, will also decrease their rates, at which they
extend loans to each other and their clients. But in a situation
where the market of inter-bank credits is idling (which is
happening in Europe at present), cheaper credits may be unavailable
for businesses and the population. For example, the European
Central Bank (ECB) lowered the refinancing rate by 1 percent in
October and November, but the cost of credits for the population
and companies practically remained unchanged by December.

The peculiarity of the current crisis is that it started amidst
low inflation and low interest rates. In the 4th quarter of 2008,
the inflation rate slowed down considerably, with decreasing oil
and food prices among the contributing factors, yet the demand for
investments did not budge. According to prognoses, developed
countries will post zero growth in 2009 at best, or a 1- or
2-percent fall at worst. This implies that the Western world risks
getting into a trap of deflation (economic decline under low
inflation) similar to the one the Japanese economy has been trying
to overcome for more than a decade.

The evil of deflation is that it limits domestic investments and
is conducive to capital flight. Monetary authorities lose the main
lever that could be used to speed up economic growth – the
opportunity to lower interest rates. Deflation is first and
foremost dangerous to the euro zone. European business has become
accustomed to an evolutionary and moderate monetary policy; the ECB
rarely changes its rates, and the range of their fluctuations is
quite narrow. Conversely, U.S. entrepreneurs have long got used to
the aggressive and jerky interest rate policy by the Federal
Reserve System, so the U.S. will be able to pull out of deflation.
According to the January forecast by the European Commission,
inflation in the euro zone will make up 1 percent in 2009, a
two-fold decrease from the normal level. In Great Britain, the
consumer price index is expected to fall to 0.1 percent.


In 2009, countries with developing markets will account for 100
percent of the growth of the world’s GDP, which is unlikely to
exceed 2 percent. According to forecasts, their economies will grow
4 to 5 percent, whereas the GDP of developed countries will fall
1.5 to 2 percent. In 2004-2008, the average GDP growth rates in
developing states reached 6 to 8 percent a year, exceeding the
economic growth in developed states (pacing at 2 to 3 percent a
year) by more than three times.

The crisis is quite painful for young market economies, despite
positive dynamics there. In recent months, the IMF approved bailout
loans for Hungary, Kyrgyzstan, Ukraine, Iceland, Belarus, Latvia
and Serbia, worth a total of 40 billion dollars. IMF missions
reported alarming conclusions after visiting Uzbekistan, Vietnam
and Kazakhstan. The crisis is setting an almost impossible task
before countries with developing markets – that of modernizing
market mechanisms and strengthening the state’s position in the
economy, although their economic system is deformed a priori, while
international practices and standards ignore the fact of this

Whereas Western countries have to tame just one dragon – the
markets, developing states have to deal with two “monsters” at once
– the markets that got out of control and the inherent defects of a
transitional economy. Some of these defects stem from the
“catching-up” type of development – a relatively low standard of
living of the population and high GDP growth rates. Consequently,
almost all macroeconomic indicators fluctuate within a broader
range, compared with countries with developed economies. Market
situation changes, for example, in Mexico and Hungary, are much
more pronounced than in the U.S. or Germany. This “roll” is a
natural consequence of fast economic growth and insufficient
stability of the economic system in general. As a result, any
unfavorable changes on world markets (or external shocks) are more
painful for developing markets than developed ones.

The fuel and food price hikes in the world pushed the inflation
rate in Asian states with developing markets from 4 percent in 2007
to 8 percent in 2008. Compare: the average annual consumer price
index in the euro zone increased to 3.3 percent from 2.1 percent.
The reason behind the difference is high energy consumption of the
GDP, and a large share of foodstuffs in family budgets of
developing states. On the whole, inflation is a sore subject for
these countries. It is generated by high economic growth rates and
frequent pay rises, a characteristic and necessary measure (from
the social point of view) for the “catching-up” type of
development. In addition, budget deficit can push up the inflation,
following huge spending by the state on modernizing production,
technological development and welfare programs.

Low interest rates are not possible under high inflation, which
itself creates inflationary expectations. A vicious circle is thus
formed, which is hard to break.

According to a forecast published by The Economist, inflation in
Russia, Turkey, Ukraine, Kazakhstan, Uzbekistan, Vietnam, Argentina
and Bolivia will reach 10 to 15 percent in 2009. In Venezuela, it
may increase from the current 30 percent to 40 percent. In Brazil,
Mexico, India, Indonesia, Lithuania, Latvia, Estonia and Bulgaria,
prices are expected to grow 6 to 7 percent.

The second part of the problem stems from the fact that
globalization influences developing countries not in the way it
influences the developed world. However, the global rules of the
game are determined by the interests and practices of developed
countries. Importantly, national market systems in the West matured
in the conditions of more or less free trade and closed financial
markets. States that embarked on the road of capitalism in the
1990s had no such margin of safety. With the possible exception of
China, they quickly liberalized foreign trade, and found themselves
de jure in equal, and de facto in subordinate relations to the main
financial centers and currencies of the world.

Not surprisingly, many of their crucial economic inter-relations
acquired quite a different shape compared with those of their
Western partners. During the past decade, a majority of countries
with developing markets had large inflows of foreign capital,
especially short-term ones. This is understandable: high rates of
growth transformed into high yields of stocks, which attracted
investors from Western countries with slower development rates.
Since the financial markets of young economies are not large, the
increased external demand for their securities was vigorously
pushing the rates of their currencies upwards. According to the
Bank for International Settlements (BIS), the Russian ruble
appreciated against the majority of currencies in the world by 90
percent in the period from 2000 to the middle of 2008 in real terms
(which takes into account an adjustment for inflation); the Czech
koruna appreciated by 70 percent; and the Hungarian forint by 60
percent. During the designated period, the currencies of Brazil,
India and Poland appreciated by 40 percent each, on the

But since last autumn, when markets experienced shortages of
liquidity, investors rushed to convert their funds from “exotic”
currencies into dollars. The increasing inflation and the general
worsening of the economic situation in countries with developing
markets only speeded up the outflow of short money. As a result,
the Brazilian real fell by 26 percent, the Mexican peso, the
Indonesian rupiah, the South Korean won and the Polish zloty fell
by 15 to 20 percent, and the Hungarian forint and the Czech koruna
by 12 percent each over the last few months of 2008.

The currencies of the three Baltic States, pegged to the euro,
are still within the designated corridor. But the margin of their
strength is diminishing before our very eyes, as are the reserves
of their central banks. The situation is particularly difficult in
Latvia: the inflation rate in this country has reached 15 percent,
and forecasts for 2009 show a 7-percent decrease in the GDP. If IMF
and EU loans received by the country fail to save the Latvian lats
from devaluation, the currencies of Estonia and Lithuania will come
under pressure.

Another peculiarity of transitional economies is that the
authorities have to fight for the stability of prices and stability
of the exchange rate at the same time – the tasks the developed
states never combine because they are mutually exclusive. For
example, the European Central Bank has always underlined that its
key and only objective is to keep prices stable, and that it does
not handle the euro rate.

Things are different in countries with developing markets. The
population there can easily slip away from the national currency to
euros or dollars, so normal economic development is impossible
without a stable exchange rate. A falling exchange rate provokes a
rapid derangement of the national monetary system, and more stable
foreign currencies begin to edge out the national currency from
circulation, which pushes up inflation even more, cuts investments
and devalues the local currency. Today, the world’s expert
community does not deal with this issue in earnest, while
international organizations do not issue recommendations to
developing countries. Each of them resolves the problem at its own
risk, as a rule in a “manual control” mode.

There is a tremendous difference between developed and
developing states in terms of monetary and credit policy. The above
loaning pattern (the central bank gives money to commercial banks
and the latter extend loans to companies and the population) exists
only theoretically in transitional economies. Indeed, the central
bank fixes the refinancing rate, which is the reference point for
rates on the inter-bank market and the final rates for clients. But
commercial banks do not borrow from the central bank, so the
borrowing pattern does not materialize. The reason is simple:
interest rates in developing countries are always higher (due to
inflation and fast growth) than in developed ones. In the
conditions of globalization, there is no need for local commercial
banks to borrow from the central bank at 10 percent interest per
annum, if they can borrow from foreign banks at a half-price rate.
That is, the disproportion in interest rates in developed and
developing countries, paralyzes the refinancing mechanism in the
latter. As a result, the state loses a crucial instrument of
economic regulation.

Therefore, developing countries, often accused of excessive
state regulation, have far less freedom in macroeconomic policy
compared with developed states of the West. Using a truncated
toolbox, they encounter tasks that their stronger partners have
never faced, and that have no adequate solutions in modern economic


Many think that the on-going crisis will stimulate
unconventional, bold solutions and help overhaul the existing
rules. According to Deutsche Bank CEO Joseph Ackermann, 2009 will
go down in history as a year of complete reconfiguration of the
world financial system. Director of the IMF European Department
Marek Belka adds that “the crisis could generate political momentum
in favor of deeper reforms that seem impossible in normal

The crisis has showed that neither national nor international
bodies failed to correctly assess the risks that had emerged on the
financial markets in recent time.

The crisis was not predicted, so no measures were taken in time
to ease its intensity and scale. Several oversights became obvious
in methods for monitoring financial markets. At present, banking
supervision systems operate on the national scale, whereas
financial markets have become global. The share of foreign capital
in the aggregate volume of funds attracted by banks keeps growing,
as does the scope of their international operations.

It is easy now for investors to choose which securities are more
attractive: national or foreign. The same applies to loans.
Consequently, the interest rates on government bonds and stock
markets of various countries become increasingly dependent on each
other. Whereas economic slowdowns in the U.S. earlier triggered
corresponding slowdowns in Europe only several months later, there
was no time lag this time. The high dependence of developing
countries on exports to the U.S. and other Western states, as well
as on world fuel prices and the international movement of capital,
did not let them protect themselves from the crisis.

Now the international community’s efforts are directed towards
working out international rules that would help prevent the
recurrence of such a crisis in the future. To this end, the leaders
of the world’s 20 largest countries met in Washington on November
15, 2008. Their final declaration began with the phrase about the
readiness to “work together to restore global growth and achieve
needed reforms in the world’s financial system.”

The document noted the necessity of major improvement of the
international regulation of financial markets, enhancing their
transparency, strengthening the international regulation of
trans-border flows of capital, and carrying out reforms at
international financial institutions, while attracting to this task
countries with developing markets, too.

Prior to the meeting, the IMF and the Financial Stability Forum
(FSF), a body created after regional crises of 1997-1998),
published a joint statement on the division of their spheres of
responsibility. It was confirmed that the objective of the IMF was
to monitor the international financial system as a whole, while the
FSF should work out international standards of financial
supervision and regulation. Together, these two institutions will
be setting up early warning mechanisms. The IMF will assess
macro-financial risks and systemic vulnerabilities, while the FSF
will assess financial system vulnerabilities.

The crisis showed an obvious lack of knowledge about important
economic processes and interaction. For example, complex methods to
test banking systems have been developed in recent years, with the
use of state-of-the-art econometric instruments. Stress-tests were
run in 2005-2007 in a majority of EU countries. They all showed a
high stability of banking systems – which the world crisis quickly
disproved. It turned out that the tests did not take into account
psychological factors and the system behavior of financial
institutions. Furthermore, it has become obvious by now that market
operators around the world were acting pro-cyclically before the
crisis. During the boom stage, banks and investment companies were
only pursuing maximum profit and did nothing to limit their future
losses. In other words, they were making things worse.

The fact that the acute shortage of liquidity on financial
markets occurred after years of intensive increase in money supply
indicates little knowledge of the mechanism of monetary circulation
in the conditions of globalization. Top officials of the Central
European Bank acknowledge that both inflation and deflation
processes at low interest rates have not been sufficiently
analyzed. This has even more significance for the specifics of
economic processes in countries with developing markets. There are
all reasons to assume that the crisis will give a powerful impulse
to the development of economic science and boost international
cooperation in this field.

The development of regional financial cooperation is another
measure. The EU has already publicly acknowledged the necessity to
step up interaction between supervising bodies of various
countries, and work out general principles of control over
financial markets. Monetary authorities of a number of countries,
especially, small and open ones, have insistently called for
creating uniform supervision bodies for the EU. The crisis has made
it clear that the European Union has to improve its legislation
regulating trans-border banking.

For example, in Finland, where two of the main three banking
networks belong to Swedes, apprehensions have been voiced starting
late last year that anti-crisis programs, approved at headquarters,
would be aimed at preserving parent businesses. Meanwhile,
affiliated banks in Finland are of strategic significance, and
their shutdown would deliver a blow to the whole national

The crisis has seriously complicated the situation in small and
open European economies which are not part of the euro zone. In
Switzerland and Denmark, analysts say that if these countries were
part of the monetary union, their financial markets and national
currencies would not have come under such heavy external pressure.
The difficult situation, in which the Baltic States’ economies have
found themselves due to problems in the banking sector, has only
strengthened their resolve to enter the euro zone as soon as

The necessity to boost regional integration is broadly discussed
in Asia. From 1990 to 2007, the share of regional trade in the
whole foreign trade of 15 countries in East Asia – ASEAN plus Three
(China, Japan, and South Korea) – increased from 43 to 54

ASEAN states created free trade zones with China, Japan, Korea,
India, Australia and New Zealand. In response to the financial
crisis of 1997, the region set up a network of credit lines to
fight speculative attacks on the currencies of the participating
countries. In late November 2008, Bangkok hosted an international
conference “The Future of Economic Integration in Asia.” 
Governor of the Bank of Thailand Dr Tarisa Watanagase noted that
“while we see significant adverse impacts of global integration,
Asian economic integration, in fact, has a crucial role in helping
a number of our regional economies withstand this enormous external
destabilizing shock.”

On the agenda now are such issues as the liberalization of the
market of financial services and the harmonization of the standards
of financial activity, including accountability. But the main
objective is to set up a deep, liquid and stable financial market
in the region.


Russia needs to make the best use of opportunities, emerging
during the acute phase of the crisis (presumably until the second
half of 2009), to convert its international cooperation in the
financial sphere into a new substantive quality.

First: It should raise, together with several CIS (Commonwealth
of Independent States) and/or SCO (the Shanghai Cooperation
Organization) partners, within the framework of a G-20 summit,
scheduled for April, an issue of setting up an international center
to study macroeconomic processes and policies in countries with
developing markets. The functioning of such a center under the
aegis a leading international financial institution will help

1) attract the attention of the international economic community
to problems of transitional economies;

2) raise the level of knowledge about the patterns and
principles of their economic processes;

3) work out better methods for carrying out monetary, currency
and economic policies in this group of countries;

4) take into account the specifics of the fledging markets in
working out international financial control standards. On the
whole, the measure will contribute to the movement towards a
multi-polar world within the scope of a global economic dialogue
and G-20 meetings.

Second: It is expedient to put issues of anti-crisis settlement
and crisis prevention in relations with the European Union on the
agenda of the next Russia-EU summit in mid-2009. This subject is
politically neutral and has an important practical content, which
everybody acknowledges. The fact that a number of EU countries,
including former Socialist states, have found themselves in a
difficult economic situation, will contribute to the development of
productive dialogue between Russia and the EU in this field. It
should be taken into account that Sweden will take over the
rotating EU presidency from July. This country has one of the
world’s best economic schools with strong positions in issues of
monetary circulation, finance and exchange rates.

Third: The crisis should be used as the starting point for a
decisive breakthrough in financial integration within the CIS
framework. Until now, there have been no tangible results in this
sphere of cooperation, although the 1998 crisis in Russia quickly
spread to other CIS states and now these countries are experiencing
serious economic difficulties. Meanwhile, the region has all
opportunities for active use of the ASEAN and EU experience in the
stabilization of national currencies, integration of their national
stock markets, harmonization of financial standards, and the
development and unification of trans-border payment systems.

Resisting the crisis and developing international cooperation in
this field should be made central issues on the agenda of the
coming meetings of CIS governing bodies. They should adopt clear
programs of actions that would meet the best international
practices. In order to accomplish this, Russia (on its own, or
together with active partners, such as Kazakhstan) should
coordinate the issues of technical support for future projects with
international groups of experts, for example, from the Central
European Bank, which carries out such activities in some third