Paralysis in Moscow Jude Wanniski April 13, 1990

My trip to Moscow, April 6-10, hosted by the State Bank of the USSR, confirmed my sense of paralysis at the center of the government. The economic policymaking team faces a seemingly impossible political paradox that confounds it at every turn. The economy continues to disintegrate and the only solutions devised, whether radical or incremental, seem to lead toward an inflation. This would wipe out the savings of the citizenry and the annuities of pensioners, and at the same time force drastic adjustment problems for industry almost too colossal to contemplate. There is a faction in the government pushing this "austerity" solution, modeled after Poland's Mbig bang," but as far as I can tell it is more identified with Boris Yeltsin, who is demanding radical action to break the deadlock. It is Gorbachev, though, who would be the big loser in the economic collapse that the Hbig bang" would produce. In the squeeze, there would be no holding the ethnic republics.

My five meetings were with the following: Deputy Prime Minister Leonid Abalkin, wha is in charge of the economic reforms (Abalkin also retains his position as director of the Institute of Economics of the USSR Academy of Sciences); Dr. Boris Milner, deputy director of the Institute of Economics of the Academy of Sciences; Stanislaus Shatalin, a member of Mikhail Gorbachev's 15-member Presidential Council and an M.P. with academic credentials in economics; Viktor Geraschenko, director of the State Bank of the USSR; and Viacheslav Zakharov, his deputy.

Here is the situation: There is uhiversal agreement that price reforms are essential to the success of perestroika. But if prices are decontrolled, thereby free to reflect supply-and-demand conditions, they would soar. Wages and other industrial inputs would climb as well. Where markets are free, ruble prices are generally three to ten times higher than the decreed price. In discussing this problem with the Soviets, I used the price of tomatoes as a proxy. The controlled state price is 3 rubles per kilo, when they can be found. The farmer's market fetches 15 rubles per kilo. The assumption everywhere is that price decontrol would lift all tomato prices near the higher level.

My recommendation is that they deflate the ruble, that is, to have it appreciate to its official level! The move would pull the price of tomatoes to the lower level of 3 rubles, or close to it. This would solve the political paradox Gorbachev faces. The value of the national savings pool, about 400 billion rubles, would be preserved. Purchasing power of the pensions would also be held, and nominal prices of industrial inputs would not go up.

The idea seemed strange to the Soviets, who of course equate deflation with depression. "Deflate? But our intent is to increase production," said one, who brought up Winston Churchill's deflation of ^he pound in 1925. Here I made my central insight The Soviet Union has an advantage in this situation over Western economies, which cannot use deflation as a policy tool without causing anguish to debtors, who are forced by the deflation to liquidate nominal debts with higher real earnings. When Churchill pushed down the price of gold to its pre-war parity with sterling, he caused just such pain. The U.S. deflation of 1873-79, with gold returned to pre-Civil War parity, also caused excruciating pain, the "cross of gold," as Jennings Bryan called it. But there is virtually no private debt in the USSR, I argued, so the government can deflate at mil! In so doing it would restore value to savers, pensioners and wage-earners. The ruble could be immediately convertible, this year, not years from now after the smoke clears from a big bang.

The government is now planning a huge bond issue, offering RIO billion to individuals and R60 billion to state enterprises. The 5% bonds mature in 16 years, a design of the finance ministry. My opinion, shared by several of the Soviets with whom I spoke, was that the issue would fail. The state enterprises would have to swallow the paper because they would be required to take it up. Individual citizens, though, would be out of their minds to take rubles out of their liquid savings accounts paying 2% and get a slightly higher interest rate in exchange for illiquidity — especially when the government is being pressed toward a price reform the people know will inflate away the value of the bonds.

My advice was to guarantee the R10 billion in gold, at 400 or 500 rubles per ounce from the current 2000. This would reflect tomatoes at 3 rubles per kilo. The bonds would be snapped up at 3%, not 5%, at home and abroad. And by offering this guarantee on the one issue, the government would instill confidence that the larger R60 billion issue to state enterprises would hold its purchasing power over 16 years. That is, by guaranteeing the value of some of its ruble obligations, demand for all of its ruble obligations would climb, including non-interest bearing ruble notes themselves. The government could not repudiate part of its obligations, through devaluation, without covering the gold coupons with ever-increasing nominal amounts. The 5% rate would begin to look good, not ridiculous as it does now. The success of the issue would lead in the direction of formally guaranteeing the purchasing power of all its debt obligations. You can't expect the people to have confidence in the ruble if the government itself does not, I advised. The people have been betrayed by government promises for so long that nothing less than a gold guarantee can now reestablish the ruble as the country's basic unit of account.

The government has gone so far as to issue bonds backed by cars, television sets, even refrigerators! It is very slow going, though. Only the car and TV bonds sell, with maturities in 1994. The problem is that people know they will have cash needs four years out, but that it might be for something other than a fridge. This is the function gold serves, its liquidity as a commodity making it an ideal proxy for all goods and services. Indeed, the citizenry has taken to hoarding soap and detergent, infusing them with monetary properties. The average household now has seven years worth of detergent stored, and as soon as the government buys more abroad, it disappears from the shelves. It won't spoil and vermin won't eat it, so it has durability and the fungibility of money. Poor man's gold.

My basic theme was that the government leaders have to stop thinking of ways to strengthen the state at the expense of the people. In the case of the ruble, price reforms that lead to 15 ruble tomatoes is nice for the state because it implies a deep repudiation of the state's debt obligations. A deflation to 3-ruble inflation seems bad for the state, because it increases the state's debt burden. But it's great for the people! It puts all the burden of adjustment on the state, which has broad shoulders. The transition would be eased immensely by putting more state assets into the hands of the people, not vice versa.

Similarly, there's plenty of talk of selling apartment houses and industrial enterprises to the citizenry, but always at prices that maximize the return to the state. I urged that they think seriously of essentially giving these assets to the people, at deep, deep discounts. This would liquify the housing market and put the equity of industry and agriculture into play in the most expeditious way. The state, in turn, is strengthened as the increased efficiency and productivity of the assets is translated into booming tax revenues. The idea, I explained, is not mine, but Thomas Jefferson's. He not only sold off the western public lands at $1.25 an acre, but threw in the mineral rights!

Were they listening to me? Yes, but. At times I had the feeling I was offering advice from the grandstands to a runner in the 100-yard dash. The level of enthusiasm varied. Hasty meetings with busy men in the midst of crisis planning are not usually fruitful. The best meeting was with Geraschenko, the director of the state bank. But then I've now met him four times, and he is beginning to see into the unconventional ideas I offer. And they all seemed to realize conventional ideas will not get Gorbachev out of his political paradox. Shatalin, who is one of Gorbachev's closest political allies, told me he wasn't sure my ideas were good, but he liked them because they were bold and different, worthy of exploration.

At the moment, policies are being prepared at a dizzy pace, to be announced over the next several weeks, they say. But without a dominant strategist with an avenue out of the paradox, the plan taking shape resembles a crazy quilt, ideas stitched together from here and there to minimize risk. A "little bang," perhaps, only a doubling of prices, a little decontrol, and a set of new social programs to cushion the blow. When it fails, a new quilt will be sewn, following the patterns of Latin America.

I've been observing for a year that perestroika can't succeed without a convertible ruble. Yet there are no plans for monetary reform at all in the current set of patches. The men I met with were clear that anything can change, priorities could shift, they couldn't rule out anything. And they may call on me soon, to at least sketch out alternatives. In any case, I said, I was at their service.