The Mechanics of Soviet Banking
Part III of a Discussion on the Operational Details of Russia's Transition to Capitalism
Part of a series on the operational details of Russia’s transition to capitalism
Much like the modern Russian mafia emerged as a response to Soviet organs’ inability to adjudicate commercial disputes, the modern Russian banking system emerged as a response to Soviet banking’s failures to provide a sound system of money and finance. While the monetary collapse of the Soviet Union was related to the political collapse, it happened on a largely separate track.
The fall of Soviet banking and the birth Russia’s modern banking system is a drop-dead fascinating episode in the history of infrastructure. But it won’t make any sense without some background on the hows and whys of Soviet banking.
You may recall that all production in the USSR happened according to the economic plan, and in the total absence of any price signals. In fact, price signals had been criminalized. What does banking for such an economy that even look like?
The shape of Soviet banking is so strange that it would be disorienting to navigate without a proper frame of reference. So let’s start with a primer on the anatomy of banking systems.
Banking as Storing and Teleporting Value
Banking serves two purposes: storing value and, as Patrick McKenzie says, teleporting it across space and time. Across history, there have been many, many ways of storing and transporting value. But in the last 200 years or so, the evolutionary paths of the world’s banking systems have largely converged. While each one has its quirks, as a set they now have pretty much arrived at the same organelles:
One Central Bank.
Central banks are responsible for maintaining the world’s faith in their currency. They do this by A) managing the currency’s supply and circulation, and B) backstopping commercial banks as their lender of last resort.
Many Commercial Banks.
Commercial banks take deposits from customers and then allocate credit to borrowers. They make money by lending at a higher interest rate than they take from depositors. Their price floors are set by interest rates, which are set by the system’s central bank.
Payments Infrastructure to Glue it All Together.
If money is the ultimate example of network effects, payments infrastructure is what holds that network together. Banks work together to design payment networks that make it easy for them to facilitate transfers of funds. This often-overlooked logistical work is why, for example, a dollar in Kansas is worth as much as a dollar in New York (which, by the way, only became the case about 100 years ago). Over time, bits of payment infrastructure tend to grow into their own participants in the banking system.1
There are plenty of supporting cast members2—from markets for various financial instruments, to reporting agencies that credit score borrowers, to private payment networks, and regulators to prevent fraud, undue risk, and predation. But ultimately, they all aid in banking’s two goals of storing and moving value.
Banking as Revealed Societal Preference
Banking regimes and their histories are immensely fascinating, not just because they involve head-turning sums of money. Even more so, banking systems are portraits of revealed societal preference. A close inspection of any banking system will uncover volumes about the values of the society that made it.
Banking exists to move and store value. And it can’t do that without some clear notions of what that society considers valuable, what activity and actors it considers trustworthy, what it considers unjustifiably risky, and what income streams it considers thermonuclearly unethical, and so on. Banking systems can give surprisingly concrete answers to these abstract questions.
Want to understand how trust works in a society? Well, how difficult is it to draw funds from a customer’s account without requiring their explicit sign off for each individual transaction?
How many pages of paperwork do you need to fill out to access the payment rails to do this? Or do you need to wine and dine the head of a bank to butter them up for a “strategic partnership”? Will the bank need you to indemnify them against any abuse of said payment rails, should your access ever be compromised? Do said payment rails even exist?3
Want to understand who’s considered elite? Well, bankers are entrusted with society’s wealth. So where did all their banking executives go to school? Where do those bankers try to send their children to school?
You can also invert this question to gauge the importance of finance in the society: what’s the educational background of a randomly selected banker? In the United States, it’s likely an elite undergraduate program, and a similarly elite advanced degree. (Spoiler alert) in the Soviet Union, fewer than 1 in 5 people in banking had a college education.
Want to understand people’s faith in their public institutions? Well, how long ago was their country’s last currency reset? In what denomination do people prefer to keep their savings? How long can they typically stomach holding their funds in the national currency before changing to their money of choice?
How many years has it been since people bartered rather than transacted in currency? Another fun inversion: does that last question seem weird to you? Did you ever consider that YOU might be weird—in strictly world historic terms—for thinking that question is weird?4
Want to know how a country seeks to improve the lives of its citizens as a matter of national policy? Well, what types of economic activity enjoy government-subsidized credit? Conversely, what types of value chains find themselves structurally disenfranchised from payment infrastructure? Who are the banks worried to serve, lest their executives go to jail for money laundering, or aiding and abetting some terrible crime?
Are you feeling it now, Mr. Krabs?
My gist is that banking systems are how societies implement their social contracts. Propaganda and founding mythologies are a great way to hear a society self-express its values. But banking is the institutional muscle tissue that a society builds up to A) do more of what it values, and B) store the wealth that it creates in the process. And because of this, banking is a more honest portrayal of a society’s values.
Now describing banking as a revelation of preference might seem counterintuitive. The artifacts of banking are dense ledgers, profit and loss statements, graphs of current account balances and interest rates. The stuff hardly reads like a winning politician’s campaign slogan. But without a doubt, there are questions that you can ask any banking system understand the motivations that animate it.
To my recent surprise, this seems true regardless of distances of space and time. This is because there are questions that every banking system has to answer as it decides how to optimally store and move value for the society it serves. While far from an exhaustive list, here are some of the questions I ask every banking system I encounter:
How does the currency work? How does it hold value?
What is the societally optimal amount of credit?
Who does the Bank serve?
How does the Bank stabilize itself?
Where do the practically guaranteed profits generated by the Bank go?
Who gets to run the Bank?
If history is music, you can say that the notes of banking history are the myriad combination of answers to these questions. And we can make out the song of any banking system by reading its story with these questions in mind.
With that bit of framing, put on your scuba gear—we’re ready to dive in.
Soviet Money’s Conundrum
The single best entry point to understanding a banking system is its currency. In order for banks to store value, the currency held in their accounts has to be able to hold value itself.
So let’s look at how the Soviet Ruble pulled this off. Like the US dollar after 1971, the ruble was deemed valuable simply because the government issuing it said so. That’s about where the similarities stop though.
You see, at the heart of the Soviet monetary system was a very unique conundrum. That conundrum came from a central goal of the Soviet project: the abolishment of price discovery.
You see, a command economy only works if the economy can be commanded. This means when the economic planners declare that a liter of vodka costs a ruble, the price needs to stay put. What’s the point of a command economy that won’t follow instructions?
On its face, this seems like a simple matter of enforcement. Perhaps you send plainclothes police around to liquor shops to ensure they aren’t marking up prices. But even if you could force the stores into compliance, you wouldn’t solve the need to price seek. What could you do? Make it illegal for people to complain the vodka shortage?
At best you’d just push the arbitrage opportunity somewhere else. Enterprising go-getters would buy out the vodka stocks at their local, price-compliant liquor store. They’d sell it to neighbors and acquaintances for a price deemed fair by all parties. After all, vodka’s constantly out of stock and they have the only supply in town.
Over time, these vodka brokers would better satisfy demand than the formal market. Over time, as vodka brokers better understood their costs and customer demands, they’d sacrifice some of their margins to make their business a bit more predictable. The brokers would bribe store managers for advanced access to vodka before they hit store shelves, effectively front-running the competition. Tada! Without anyone in particular setting out to make one, an efficient shadow market for vodka would appear.
This isn’t a hypothetical. It actually happened, and Russia’s informal vodka markets were crucial training grounds for many violent entrepreneurs (and their customers) in the years before perestroika.
Price discovery like this was anathema to the Soviet project. The people in the shadow market were criminals under the Soviet code. And they faced years of back breaking labor in gulags if they got caught.5
Now here’s the doozy: the Soviets also wanted economic growth.6 But it’s impossible to engineer economic growth (at least at the rates we’ve seen for the last 150 years) without a steady expansion of the money supply.7 But in increasing the money supply, you would naturally encourage price discovery. Some firms would get access to the new money stock sooner than others, and would buy out the existing supply of goods and services, driving up the price for everyone, and thereby setting a new equilibrium.
So somehow, the Soviets needed to devise a monetary system that would allow them to grow the money supply without hampering their ability to dictate prices. Imagine your boss throws this monetary dilemma on your desk and says "I need a solution to this by Friday". What do you do?
Why of course, you construct a two-tiered currency system.
A Tale of Two Rubles
The primary currency was the “hard” ruble. It’s what Soviet workers were paid their wages in, and the currency they used for all consumer transactions. Here’s what the hard ruble looked like:
What did the second ruble look like? Well there are no photos of it, because it never existed in material form. The beznalichnyy (“cashless”) ruble was used exclusively by Soviet state enterprises to trade with each other. Its name stems from the fact that there were no physical banknotes for these rubles, making them (to my knowledge) history's first totally virtual currency.
An aside: the astute reader will note the irony that virtual currency, a field now dominated by crypto-libertarians, was essentially invented by their arch nemesis. As we’ll later see, the Soviets built solutions to many of the same problems as cryptocurrency does, but from the exact opposite direction. End aside.
The hard ruble flows on the consumer circuit, going directly from enterprise payrolls to worker wallets. Meanwhile the virtual ruble zaps between state enterprises, as a kind of trade token. And never the twain shall meet.
The two rubles were separated by two-layer a firewall. First of all, there was no method to redeem one type of rubles from the other. And second, private citizens couldn’t even open the kind of account that held virtual rubles.
The two tier ruble system resolved the Soviet monetary dilemma. At least it seemed to at the time. Its firewall shielded wages and consumer prices from the inflationary effects of increasing the virtual money supply. This allowed the economic planners to steer economic output with credit, without any fear of blowback.
How did they do this credit steering? I think it’s high time we introduced the Soviet “central bank”.
The Monobank
I use scare quotes when describing it as the Soviet “central bank”, because the word “central” suggests a position relative to other banks. But Gosbank was the only bank in the Soviet banking system.
This architecture was called a “monobank”, and it was common in the command economies of yore. The name explains itself: Gosbank handled all banking activity in the USSR. From household savings to funds transfers between the enterprises. There were no commercial banks beneath it.
Gosbank’s only monetary instrument was the ability to credit virtual rubles to different state owned enterprises.8 They would allocate virtual rubles based on factors such as each state enterprise’s relative importance to the Soviet economic plan, the health of their finances after trading with other state enterprises (in a kind of proto-market).
So when Gosbank wanted to increase the supply of rubles in the Soviet economy, it did so by increasing the virtual ruble budgets of specific state owned enterprises, an arcane monetary instrument called “direct credit”. This another stark contrast to modern banking systems, where central banks don’t interface with individual companies.
Gosbank’s Infrastructure
As the only banking institution in all of the USSR, Gosbank had expansive responsibilities that would surprise the market-native mind. Its mandate was embodied in a multi-function payment network was known as the card file system. Each functionality in the cardfile system was devoted to its own channel. Each channel would prove to be a Chekov gun in the transition.
One cardfile channel was devoted to settling tax payments and the receivables of other large establishments like utilities and railroads. This channel allowed Gosbank to draw funds from accounts without the payer’s prior authorization. The equivalent functions in the United States were built by the card networks and the ACH system. Both of these have robust dispute and chargeback resolution mechanisms that keep merchants overwhelmingly in good faith when drawing funds from customer accounts. No such mechanisms were existed in the USSR. This was a sensible design decision at the time, because debiting counterparty was the government (and often, the paying counterparty was also the government!).9 But it would prove to be a critical Chekov gun in the transition.
This ability to unilaterally debit accounts also extended to different branches of Gosbank, which were located in the capitals of each Soviet republic. These branches could unilaterally issue debits, withdrawing from their accounts at the head Gosbank branch in Moscow. This allowed the USSR to geographically control its credit postures, giving individual Gosbank branches the ability to declare their own local monetary policies based on what they felt was most needed. Another Chekov gun.
But the strangest Chekov gun of all: Gosbank tabulated the balance sheet of every enterprise in the Soviet Union. It’s a surprising but logical conclusion of the virtual ruble credit policy.
Gosbank’s credit policy intervened against the “natural” balance sheets that these enterprises would form after trading with each other. They allocated credit to cover the differential between what surpluses (or losses) the enterprises accrued on their own and how much Soviet planners believed should be available to them.
In order for it to track all inter-enterprise debts, cashless ruble transactions went through Gosbank through a channel in its settlement system call card-file number two (kartoteka dva). This made Gosbank more of the bookkeeper of the Soviet economy than its lender. The virtual ruble system was less a currency than the equivalent of tracking the entire national economy on a single Quickbooks instance.
Again, it’s both irresistible and illuminating to see cryptocurrency as the Waluigi of the cashless ruble. Like crypto, the virtual ruble existed exclusively as data in a single digital giant ledger. Also like crypto, the virtual ruble required no trust between counterparties to a transaction. But it pulled off both these features in the single most un-crypto way imaginable: by restricting its use exclusively to related parties, who themselves were all wholly owned subsidiaries of the issuer, a communist government. Kinda weird right?
Banking Cybernetics for Bazaars and Cathedrals
I want to take a moment to unpack that feeling of bewilderment we get when we look at Soviet banking. I want to suggest there’s something deeper behind your reaction than thinking you’re looking at a financial Ripley’s Believe It Or Not!. I believe that Soviet banking surprises us because it comes from a different school of cybernetics than the one we’re used to.
“Cybernetics” is a $7 word that gets reasonably and incorrectly clustered with cyberspace and science fiction. Really, it’s just the study of dynamic systems and how to govern and control them. For a more rigorous definition, I hand the microphone to Soviet mathematician Andrey Kolmogorov, who defines it as “the study of systems of any nature which are capable of receiving, storing, and processing information so as to use it for control.”
Cybernetics was a majorly influential discipline in the 20th century that cross pollinated knowledge from math, biology, information theory, engineering, and (of course) economics. I bring the discussion to cybernetics, because the je ne sais quoi that I’m alluding to here can feel either over-inferred or nearly invisible without this term to hang it on.
Cybernetics says there are essentially two ways you can better control a system. Either you A) get better at modeling—and responding—to the system’s various possible states, or you B) reduce the number of possible states it can be in. This matches the grain of an ideological fault line that software engineers recognize, of the bazaar vs the cathedral.
A bazaar-pilled society produces a very market-minded banking system, whose outputs are largely the result of commercial negotiations, refereed by regulators. This is even true of the central bank’s monetary instruments. Central banks use open market activities like trading government bonds to adjust the money supply. They also dictate interest rates, which sets a price floor for credit. And they even set guidance about future interest rates—essentially giving banks a weather forecast of how rates will look in 6 months, so no one’s balance sheets are caught off guard (though, invariably, sometimes they are).
The modern banking toolset is an impressive cybernetic accomplishment, primarily falling in the “better modeling” school. The banking systems we know and love have refined their ability to model and respond to changes in the state of the economies they try to cultivate. And they’ve built quite a toolkit for the many possible problems that can arise in the process.
The USSR, on the other hand, was cathedral-pilled (even though, ironically, the Soviets were atheist). Their economic production was directed externally, and architected according to a plan. The bank helped build the cathedral by faithfully executing the instructions of the planners.
The firewall between the two currencies, dictating prices, consolidating all of finance into a single bank, tracking every enterprise’s balance—all of these squeezed agency out of Soviet banking.10 It was a very cathedral-flavored cybernetics, that tried to steer the economy by restricting the number of possible states that it could be in. This is why the abolition of price discovery was such a critical goal.
Over time, the distribution of resources in the planned economy drifted significantly from how the market would have arranged them. Gosbank’s architects thought they were insulating their economy from profiteering and instability. But where Gosbank’s architects saw insulation, nature saw a vacuum. And nature hates vacuums.
The banking transition that followed looked much like a zombie outbreak, where the mind-virus that spread through the Soviet banking system was agency. Slowly everyone in Sovio-Russian finance began to see the scale of opportunity in rearranging and reappropriating the command economy’s resources in accordance to the wishes of the market.
The rupture of this vacuum more or less created modern Russia.
And that, we’ll get into next time.
Bibliography
Johnson, Juliet. A fistful of rubles: The rise and fall of the Russian banking system. Cornell University Press, 2000.
Johnson, Juliet Ellen. "The Russian banking system: institutional responses to the market transition." Europe-Asia Studies 46.6 (1994): 971-995.
A note on sources: there is shocking little literature available in English on Soviet banking. This Part is heavily indebted to the work of Juliet Johnson.
Credit card behemoth Visa was founded as a consortium of over 1,000 banks before eventually spinning off into its own company.
This is not a value judgement on them at all, or to say banks are more important than them. It’s more to center the camera—I’m talking about the patch of societal tissue where the Federal Reserve is at coordinate (0,0).
These are questions that the founders of many fintech startups must deal with, especially in markets with still-nascent financial infrastructure. From my time in Kenya, for example, I can think of multiple founders we personally knew (including ourselves) whose startups were blocked by some combination of these questions for many months.
Would you or your parents would find it strange to be asked these questions? I would. But my parents most definitely would not. They would tell you—with laughter—about 1992 when they had to accept canned pears from UNHCR as payment because paper money had become extremely scarce in Iraqi Kurdistan.
With a prelude like this, does it really surprise you that the people who provided the market-leading rule of law during the transition were organized criminals?
The mechanics of why are out of scope here, but worth a visit to Google or ChatGPT. For now you can accept that the dependence of economic growth on monetary expansion was a force so true and so strong that even Soviet engineers couldn’t figure out a way around it.
Because they were so disastrously bad at it, it can be easy to forget that the Soviet goal was originally to create a more productive system.
The Literature is murky on whether Gosbank provided direct credit to state enterprises for hard rubles. It certainly seems that Gosbank provided the money logistics to fund the hard ruble accounts of state owned enterprises, but it seems like those were budgets set by the economic planners
This rhymes big time with the problems faced by Gosarbitrazh, the Soviet court system that had no experience adjudicating disputes between two private parties when market reform arrived.
And indeed you could feel this (according to witnesses) in the culture of Gosbank, whose offices felt more like a postal service than a bank.