Anthony Davies

© 1998, Cline & Davies Research Alliance

Faced with the possibility of the economic collapse of the Russian economy, one might ask what actually happens when an economy collapses. An economic collapse can take one of two forms: productivity collapse, or monetary collapse. In a productivity collapse, the productive capacity of the country is destroyed such that economic transactions can no longer occur. Productivity collapses are usually the result of war and generally include the physical destruction of buildings and machinery or mass deaths among the population. In a productivity collapse, it is not necessary that the entire productive capacity of the country be destroyed, but rather, that key sectors be destroyed. For example, imagine an economy comprised of three people: Abe refines metal, Bob makes tractors, and Carol grows food. Abe sells his metal to Bob who, in turn, turns the metal into a tractor. Bob sells his tractor to Carol who, in turn, uses it to grow food. Carol sells her food to Abe and Bob. If Abe is killed in a war, then the economy collapses. With Abe gone, there is no metal. With no metal, Bob can’t make tractors. With no tractors, Carol can’t grow food. In a productivity collapse, economic activity stops because people cannot obtain the materials necessary to produce their products.

In a monetary collapse, the productive capacity of the country remains intact, but the country’s currency becomes valueless. With a valueless currency, Abe is unwilling to exchange his metal for money. Without metal, Bob can’t make tractors. But, even if Bob could make tractors, he would be unwilling to exchange them for money. Similarly, not only can Carol not grow food because she can’t get a tractor, but even if she could grow food, she would be unwilling to exchange it for money. Carol is unwilling to accept money for her food because she believes that Bob will not accept money for his tractors. Bob is unwilling to accept money for his tractors because he believes that Abe will not accept money for his metal. Abe is unwilling to accept money for his metal because he believes that Carol will not accept money for her food. In a monetary collapse, economic activity stops because people believe that no one else will give them products in exchange for currency. Here, then, is the root of what makes money valuable: that people are willing to give you products in exchange for it.

Because the country is still capable of producing products, a monetary collapse is less serious than a productivity collapse. However, a monetary collapse is still an extremely serious matter. Consider the effect on savings. When people save money, they are storing "future consumption". Putting a dollar in the bank today enables me to take a dollar out later and buy something. When a country experiences a monetary collapse, everyone who has saved money looses his entire savings. When the savers put their money in the banks, the money had value – it could have been used to buy products. When the savers now take their money out of the banks, they find that no one will accept their money – their "future consumption" has disappeared.

Consider the effect on bonds. Bonds are to money like money is to products. I can put off having a loaf of bread by keeping my money in the bank. Similarly, I can put off having my money in the bank by buying bonds. In the future, I can trade in my bonds for money which, in turn, I can use to buy a loaf of bread. If no one will take my money in exchange for a loaf of bread, then my money has no value. If I can trade my bonds in for money but the money has no value, then my bonds also have no value.

Russia’s coming economic collapse is due, in large part, to the inability of the Russian government to enact tax reforms. The government has not been collecting taxes owed it by its people and companies. This, in turn, makes it impossible for the Russian government to meet its own financial obligations (among which are making payments on government issued bonds). Faced with the inability to make payments, the government has no choice but to print more money and use the money to pay its debts. Because the value of money rests in the products it will buy, to increase the quantity of money without increasing the quantity of products simply devalues the currency. As Russians become aware that the currency is devalued, they are less likely to accept it in exchange for products, causing a decrease in the number of products produced. As the number of products produced falls, ever-more rubles begin chasing ever-fewer products, and the ruble approaches a state of zero value.

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