Lessons from the Russian Meltdown: The Economics of Soft Legal Constraints

On 17 August 1998, Russia abandoned its exchange rate regime, defaulted on its domestic public debt and declared a moratorium on all private foreign liabilities, which was equivalent to an outright default. The depth and speed of the Russian meltdown shocked the international markets, and precipitated a period of serious financial instability. Important lessons on issues of bank supervision and international stability can be learned by understanding the roots of such a crisis. The visible reason of the crisis was an unsustainable fiscal deficit coupled with massive capital flight, but what were their underlying causes? We argue that the structure of individual incentives in a context of capture of state decisions by special interests, compounded by a rouble overvaluation driven by exceptional international support, helps to explain the build–up of non–payment, theft and capital flight that led to the crisis. We offer an explicit model of rational collective non–compliance, cash stripping and rational collective non–payment which led to the fiscal and banking crisis and, ultimately, to a complete meltdown. In our view, the banking sector was already insolvent prior to the crisis, and contributed directly and indirectly to it. We conclude with a radical policy proposal for a stable banking system for Russia, appropriate for its current capacity for legal and supervisory enforcement. It is based on a segmented, narrow banking sector, concentration in commercial banking and a cautious extension of deposit insurance.