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Vladimir Sidorovich
AN ALTERNATIVE TO PYRAMIDS

The crisis as a moment of truth: it is high time to reshape the financial market on a consructive principle

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 – mobilization of resources for a more efficient investment in production, as well as insuring (hedging) of financial risks – 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 – 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 – particularly, the share of investments, attracted in the process of primary floating of stocks, is directed into industrial assets – 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 – though in a restricted scale – 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 – 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.

NEW PRINCIPLES OF REGULATION

What new principles of regulation of financial markets could compensate their negative effects?

Politicians, contrary to futurologists, are restricted in their capabilities. They are bound with the framework of the existing economic paradigm, and unwilling to change its basic foundations. According to Maxim Sokolov, qualitatively new basic principles are likely not to emerge from rational revision of the existing principles but from constituting the state of affairs on the ashes. At peacetime, we are likely to expect correction of the existing model and not a change of principles of economic policy.

It is also obvious than human passions of covetousness and pride, the major locomotors of financial speculation, cannot be cured by prohibition. On the other hand, the ontological destination of the state is "to restrict manifestations of evil and sin in the world". In the discussed context, that means that the state should drive players out of the sphere of speculative operations with fiscal levers, as well as with use of harsher methods, canalizing their energy into a more useful direction.

Regarding these considerations, we propose the following set of framework measures:

1. A tax on incomes from sale of shares.

The presently proposed tax relief for incomes, derived from sale of shares held in investor's portfolio for more than a year, is a correct measure. We believe that this term could be increased to two years, in order to more efficiently stimulate long-term investments.

However, this measure will not be workable without a significant increase of the tax rate on sales of shares held for less than two year. It is expedient to introduce a special tax for this purpose. The tax rate is to be sufficient for destimulating speculative operations, reaching 90% for the first and 50% for the second year, both for individuals and companies, regardless from tax jurisdiction.

Every FIFO transaction should be taxed as well. This requires changes in the infrastructure of the stock market which are anyway long overdue – for instance, establishing a single exchange, a single depository and registrar, as well as centralized clearing.

In early 2006, Oleg Vyugin, then-chair of the Federal Authority on Financial Markets and a well-informed official, confessed that the market infrastructure was conditioned for short-term speculative deals and not for investments. Is today's crisis not sufficient to initiate changes?

In addition, the tax reform will require a higher transparency of companies, as well as improvement of quality of corporate management. The only reasonable alternative for the special tax is return to progressive taxing of individuals.

2. A ban for unsecured short sales.

3. A ban for using shares for lending, as such deals are destined exceptionally for mastering tax-evading schemes.

4. Creation of tax levers destimulating speculative activity at derivative markets.

5. Severization of banking standards on investment in shares and short-term transactions.

6. A ban for crediting professional share trading parties and their subsidiaries as well as for any lending for purchase of shares.

As far back as in 2001, Bank of America's CEO foresaw that in several years, major investment banks would be merged by commercial banks that have a broader base of funding. Exactly this is happening today.

However, this luck of commercial banks is rather precarious. Their involvement in investing activity is fraught with temptation of using capitals of depositors – the base of funding – for covering losses emerging from risky investments. Regulating authorities are to be sufficiently competent for distinguishing more and less risky operations in the range of investment activities and to introduce adequate prudential restrictions protecting the bank from the fascination of top managers with dangerous kinds of operations.

7. A ban for stock market players to run any kind of transactions with residents of offshore zones, essential for restricting activity of international hedge funds which are not regulated by any institutions, as well as for reducing the possibility of "tax optimization: for domestic market players.

8. A ban for offshore registration of enterprises functioning predominantly on the territory of Russia and controlled by Russian citizens. In fact, according to Mr. Vyugin, "property rights of beneficiaries are outsourced to the jurisdiction of foreign states: businessmen drill, pump and saw in Russia and own and even extract profit in Cyprus, Holland, etc. Russian business in increasingly structured in the form of foreign holdings owning Russian assets, with the purpose of channeling these assets, already under foreign jurisdiction, to international capital markets".

9. A ban for IPO of Russian companies outside Russia, including the forms of ADR and GDR.

10. Toughening of prudential control over professional market parties.

11. In ads, leaflets and indentures concerning operations with shares, units of investment funds and in forward deals, it has to be written in capital letters – in a print as large as the text of the ad, leaflet or indenture – that investments in these instruments are fraught with loss of the whole invested capital.

12. For over two decades, one of the major problems of Russian economy is insufficiency of short-term resources. Mostly for that reason, Russian companies and banks (including those co-owned by the state) are forced to attract money at foreign markets. At the same time, the state allocates funds at the same foreign markets under significantly smaller interest. Therefore, one of the most immediate tasks of the state (represented by the Finance Ministry, the Bank of Russia, and the Ministry of Economic Development) is elaboration of mechanisms of long-term refinancing of banks and therefore economy. The market, especially with "infrastructure conditioned for short-term speculative operations", cannot solve this problem.

These measures, or some of them, will be undoubtedly encountered with violent resistance from the so-called professional parties of the stock market and their numerous lobbyists who will do their best to prove that in case new conditions are introduced, the market will lose liquidity, become unattractive for investments, and they escape to London.

"Not a single principle of the orthodox financial science is as antisocial as the fetish of liquidity", wrote J.M. Keynes in 1936.

It is true that a share is a part of the capital of a joint-stock company. Capital may be invested in material assets – for instance, in construction of a gas pipeline. Now imagine a pipeline that is assembled, then dismantled in an hour and assembled again. The dream of today's nomad is high liquidity of everything: any goods to be immediately purchased and resold. Today's financial market makes this dream true.

"If investment of capital, like marriage, could be made a long-term and indissoluble act, this would be a useful remedy from our current maladies. This would force the investor to focus on long-term perspectives and nothing else", wrote Keynes. He further points at the contradiction: "liquidity of investment markets rather benefits new investments then impedes them".

This dilemma, significant for Keynes' times, had been since relieved. The share of new investments in real assets in the turnover of financial markets progressively contracted: most of the reinvestment was directed into a pyramid, in which high liquidity enabled purchase of new players. According to Ruslan Grinberg's calculations, "only 2-3% of global financial operations are somehow related to the real sector, while the rest are related only to one another or to servicing the financial sector".

"We don't need your dividends!" – declared a shareholder at the recent assembly of the Russian Foreign Trade Bank (which had just decided to spend half of the net profit for dividends). This remark reflects the whole philosophy of today's financial market. A modern investor is interested only in growth of stock price and relevant speculative profit. He expects money to grow all by itself, no matter how the enterprise is working and whether it works at all. The typical dividend income is scales smaller than the return on deposits, and does not serve as an impetus for investments in shares. "Dividends are just a trammel", confessed an investment banker already in the 1990s.

It is essential to return back to the earth. The proposed measures are helpful. The chair of the Financial Markets Service also ostensibly wishes to "deter speculators". It is definitely necessary to analyze measures undertaken by European countries and creatively apply them. The principles of regulation of financial markets will be undoubtedly amended in Western countries. "Markets should serve to the society" – this assumption has become conventional in Western media and in speeches of Western politicians. The Russian financial market should also serve to the society, and not to a flock of speculators.

WILL RUSSIA BENEFIT FROM MAKING ITSELF THE FINANCIAL CENTER?

"Russia has to become a global financial center", declared our top officials last year. The idea could be quite acceptable in case the intention were focused on decoupling of the national currency from the US dollar, thus achieving independence from the US economy that was spectacularly approaching a crisis. In fact, the ruble was still pegged to the dollar, the emission of national currency depending from the dollar/ruble rate, restricting implementation of sovereign economic policy from outside.

It is true that we require a strong financial power. But what are we in fact going to create?

The sparse amount of information available from government experts suggests that the idea of the financial center was related only to the stock market. The only dream of government officials was to reap the laurels of New York and London as centers of stock exchange. "Stock exchange should be the nucleus of this center", declared the chair of the Federal Authority on Financial Markets. Naturally, the best instrument for Moscow's transformation into New York was tax relief. Smart Money Magazine reported that FAFM was going to "introduce a zero income tax rate for sale of shares for individuals, this indulgence consequently encompassing also investment companies".

Russian liberal officials obviously follow a primitive logic of mechanistic comparison: Western countries have a high level of life, and at the same time, a developed financial (stock) market, therefore, to live as nice as they do, we also require a developed financial market.

In fact, this pattern suggests copying and reproducing institutions and instruments with a doubtful substantiality. In fact, the dialectic of economic phenomena, their consistency and causality was neglected. Government dreamers overlooked the simple fact that in the West, the financial market has become a superstructure parasitizing on the already developed real sector and social state. Economic and social growth, ostensibly achieved due to the financial market, was in fact the consequence of global processes of redistribution – a form of neo-colonialism, achievable due to the underlying basis. Meanwhile, this basis was de facto challenged, immediate challenge, and sustainability of the Anglo-Saxon model was put under question.

The attempt to draw over these processes of redistribution in favor of Russia, for instance, in the form of a financial center, corresponds with imperial thinking but contradicts national interests. A developed and open financial (stock) market under the conditions of globalization is a means of attracting not direct but portfolio investments. To lure portfolio investments from the whole globe is equal to an attempt to tame locust. Regarding absence of an efficient productive basis and social protection, such kind of doting on bubbles is a pernicious occupation.