From Russia, With Default: Russian Debt Crises and Global Finance

I finished reading The Ascent of Money while sitting in New York City's Bryant Park last Saturday, with the mammoth Bank of America Merrill Lynch tower as a backdrop, the Lord of War soundtrack as background music, and the occasional stray ping pong ball to bring me back to my surroundings. After three long days of investment banking networking and meetings with various IU alumni in the city, it was nice to sit and take in the somewhat paradoxical combination of parks & rec and metropolitan mayhem that New York has to offer, all while reading about the history of finance.

One of the themes throughout Niall Ferguson's book is the inherently international nature of finance and banking, and how seemingly unconnected transactions and events can have disastrous ripple effects leading to global crisis. This is something that became all too obvious between 2007 and 2009, when the U.S. subprime mortgage and CDO meltdown led to not only an American but also a global recession from which international markets are still struggling to recover. Indeed, while the cover of the current issue of The Economist announces "Wall Street is Back," the British newspaper doubts that investment banks will ever fully regain the levels of profit and success they attained prior to 2007.

Yet massive global crises caused by national-level defaults and instability, far from being a 21st century phenomenon, have been a variation on a theme for at least a century now. Two instances that I find particularly intriguing, given my interest in Russia and Eastern Europe, are the Russian defaults in 1918 and 1998. In both cases, national-level financial problems in Russia led to global financial pandemic.

The assassination of Archduke Franz Ferdinand, which led to the outbreak of hostilities in the Balkans and ultimately triggered World War I, did not cause any financial reaction until late July of 1914. Once investors and financiers realized the impending likelihood of global war, however, they were quick to react, and one of the first victims was the Russian economy. Although Russia had one of the largest standing armies in Europe at the time, its financial and political systems were not regarded as very stable, and a massive selloff of Russian securities ensued. This in turn led to a drastic drop in value for the ruble, followed by a similar slump in the dollar once American securities were unloaded by Europeans as well. 

Global meltdown quickly ensued, as British banks were flooded with sell orders. Soon most financial systems in Europe faced a mounting liquidity crisis, which the unfolding war did nothing to help. To staunch the financial bleeding, the world's major stock markets completely shut down for several months. It was an unprecedented event and one that has not been repeated since; but it succeeded in averting a full-blown global crash that likely would have been at last as bad as the one that kicked off the Great Depression in 1929.

Returning to Russia, however, the Tsar's government simply suspended the gold standard and any convertibility of rubles into gold, which led Russian bond prices to collapse, followed in short order by the Romanov dynasty itself. In 1918 the new Bolshevik regime defaulted on all of its bond debt, and by the 1920s Russian bonds were trading around 20% of face value. It was only through forced, Soviet economic management that the Russian financial system was brought back to a semblance of life and was able to grow during the subsequent depression era of the late 1920s and early 1930s.

Russian Freedom bond, 1917. Image courtesy of Wikipedia.

Russian default precipitated a similar global crisis in 1998, again due primarily to overarching economic and political reasons. Following the collapse of the Soviet Union and the "opening" and "freeing" of Russian markets to the rest of the world, Russia's supposed emerging economy entered a tumultuous period dominated by oligarchs and overly reliant on oil revenues. Overwhelmed with political turmoil and botched attempts at privatization, Russia defaulted on its foreign and even rouble-denominated domestic bond debt in August of 1998.

The shockwaves were immediate and devastating. While the limitations and weaknesses of the Russian economy were known at the time, the Russian default blew out bond spreads, caused equity volatility to spike, and crashed market indices. Perhaps the most damaging and most (in)famous results of the Russian default, however, was its central role in the collapse of hedge fund Long-Term Capital Management. Using complex and sterilized mathematical modeling, LTCM had bet big that the markets would never lose more than $45 million in a single day. The Russian default caused the markets to los $550 million on August 21, 1998 alone. The continued losses drove up LTCM's leverage and crashed its supposed infallible modeling, leading to the collapse of the hedge fund and a massive Wall Street bailout that would foreshadow the more recent bailouts following the 2008 financial crisis.

The 1918 and 1998 Russian defaults were separated by 90 years of supposed financial evolution and progress, yet history certainly seemed to repeat itself. In both instances, the supposed financial invincibility and hubris of investors (whether Western Europeans or LTCM) was reduced to panic due to events half a world away, in a country and financial system regarded even today as tangential. The lesson to be drawn--from these incidents and from Niall Ferguson's book in general--is that as integral as international finance has been to the interconnected ascent of man and money, the key to establishing a successful financial history of your own is knowing and understanding the history of finance. In the grand scheme of things, global dynamics and international events can often be far more important than technical valuations and mathematical models.