Economics and politics - comment and analysis
20. March 2015 I Heiner Flassbeck I Economic Policy, Europe, Financial Markets

Ukraine under friendly fire – destroying an economy in order to save it?

This is the (updated) translation of an article that was published March 9, 2015 on flassbeck-economics. We intend to publish one article in English every week to allow more readers to follow closely our analysis of global and European events.

Anyone who still thinks that the International Monetary Fund (IMF), and consequently the Western industrialized countries that control it, put pressure on ‘unfriendly Leftist governments’ in order to save them is completely wrong. The IMF has pushed the Ukraine, which is considered by most Western politicians as the ultimate bulwark against alleged Russian hegemony and imperialism in Eastern Europe, into a severe crisis, thus making the country ungovernable.

The Central Bank of Ukraine has once again increased its key interest rate last week, this time by more than ten per cent, from 19 to 30 per cent. All of this goes largely unnoticed by the German media, because the German press follows an unwritten rule that they will only report positive news about the Ukraine. The Financial Times reports that since mid-January, the interest rate has doubled: a thirty per cent interest rate in a county where the inflation at the end of 2014 was just over ten per cent, while its GDP crashed by more than seven per cent last year. A further fall of five per cent in GDP is expected this year.

By the drastic increase in interest rates the central bank is trying to stop the fall of the Ukrainian Hryvnia. The Hryvnia fell almost through the floor since the start of the political crisis. From a rate of 1 to 8 against the U.S. dollar in 2013, it fell to 15 Hryvnia to the U.S. dollar by the end of 2014. One U.S. Dollar is now worth more than 23 Hryvnia. The Hryvnia lost more than 40 % of its value since the beginning of this year alone. This makes imports incredibly expensive and adds to the inflationary pressure. All of this happens under the eyes of the Western powers. Many commentators make the case that they are directly responsible for what is going on. There is massive influence on governmental policy from the outside – over and over again one hears about an ”American” investment banker who has become a minister of finance in the Ukraine.

The enormous surge in interest rates will have a catastrophic impact on the rest of economic activity. Ukrainian entrepreneurs realistically anticipate that inflation will not remain at the actual elevated level, making potential investments of Ukrainian companies prohibitively expensive. In fact, in the view of new additional IMF conditions, asking for further cuts in government spending, Ukraine is in very a dangerous situation. The desperation of the people will continue to grow and play into the hands of radical forces of the extreme right that the West does not want to see gaining power. Compared to 2013, the Ukraine surely needed a certain devaluation. But this one is going too far, given the dependence of Ukraine on imports. It would be possible for the West to intervene directly in the foreign exchange market (i.e. an intervention by central banks, which practically costs nothing) in order to stabilize the exchange rate at a reasonable level, hence allowing a decrease of interest rates and giving investments in productive capital a chance. This would be an appropriate course to follow in order to avert the catastrophic economic situation. So, why has it not happened?

The answer is simple: because it goes against the main dogma that the West has built up over the last few decades. It is a dogma that developing, emerging and transition countries all need to follow: the results of free markets of currencies must never be questioned, regardless of the economic, social, humanitarian or other costs that may arise. The IMF wrote in its latest report on the Ukraine that “Monetary policy will be geared toward returning inflation to single digits in 2016 within a flexible exchange rate regime.” This is the crucial point. It is always the same. It is the fiction that flexible exchange rates will allow to run monetary policy in a monetarist fashion. The policies of the IMF (and the US Treasury, which keeps the institution on a short leash) may run contrary to common sense and fail every time, as they did in Latin America, Asia and in Eastern Europe in previous crises, but this core principle will not be put into question. To the IMF – the core of the dogma – inflation is a monetary phenomenon and therefore monetary policies in a monetarist framework, and nothing else, and nothing more, has to deal with it. Notably, the IMF uses what is in fact an extremely simple quantitative model based on money supply in order to produce its projections and recommendations. The insulation or autonomy of an economy vis-à-vis other countries must be left to the foreign exchange market, apparently there is no choice. This is the textbook version of IMF dogma and policy and it is never questioned although it does not work at all.

This dogma, which is of course supported by a large majority of economists, can also be called the dogma that ‘the prices are always right.’ If somewhere something goes wrong, it is never the market, it is always the state. In this view, prices are always right and institutions and regulations must adapt. Furthermore, the public sector is always the first point of attack. Within the European Monetary Union, the flexibility of exchange rates has been replaced by the flexibility of interest rates on government bonds. This means, in essence, that the capital markets dictate the direction in which, as Angela Merkel puts it, ”market-oriented democracy” evolves. It can be seen everywhere. If, for example, with respect to Greek government bonds’ prices, the ECB had intervened on the capital markets early on to keep interest rates low, the whole fiasco of the Greek ”negotiations” with the Troika and the ESM (the European Stability Mechanism) would have been unnecessary.

The position of the Americans in all of this is simply hypocritical. The Americans vehemently defend the dogma that prices are always right in international negotiations and in international relations, as long as it is not applicable to them. At home, it is completely ignored. The US Federal Reserve intervened more in the markets than any of the other central banks. Even changes in the exchange rate make them extremely nervous and they threaten with sanctions if the dollar becomes too strong. Ironically, exchange rates do not affect the U.S. economy as much as many developing economies because international trade is not critical to the U.S. economy. The old motto applies that the US government is meant to use in its advice to developing countries: Do as we say, but do not as we do!

And so the madness continues. The Ukraine now has a new German shadow minister for finance: Peer Steinbrück, the former German Finance Minister. No doubt, the post, being financed by an Ukrainian oligarch, will legitimize Steinbrück to fly to Washington and tell the economists of the IMF and the Treasury how market economies and currency markets work. Steinbrück is a real expert, although, unfortunately, no one knows for certain what Steinbrück really knows. He has written a book on the financial crisis and its management, but he preferred to disclose nothing of his supposed knowledge. However, on the basis of the policy measures that he recently recommended to the German Government – reduce public consumption, increase investment and stick to the reduction of public debt – he may substantially increase the intensity of the friendly fire in the Ukraine. Ultimately, his advice could amount to bombing the country into abyss – in order to save it of course.