Investors Should Hold Off on Investing in Russia

When I awoke to the news that the Russians had invaded Georgia, I wondered for a moment if it was a bad dream. This is 2008, not 1968, isn't it? Haven't the Russians, not to mention the Americans, learned anything during the past 40 years?

For investors, these are more than academic questions. Although most markets outside of Russia itself — even oil markets — seemed to shrug off these dramatic developments, a return to the Cold War would have grave implications for the global economy. Already, there promises to be a diversion of resources from productive investment toward bulking up military defenses in Eastern Europe. Any military clash between Russia and the U.S. would be potentially catastrophic for the march toward democratic capitalism which has fueled strong market performance around the world since the collapse of the Soviet Union. The "peace dividend" would have to be repaid — with interest.

If I really believed in that dire scenario, I'd be pulling out of stocks and parking my savings in the safest possible assets. But it's not 1968, as David Remnick argues persuasively in this week's New Yorker. Even if the rosy optimism that accompanied the fall of the Berlin Wall and the so-called "end of history" has proven to be naive, the world has changed dramatically and irreversibly, and for the better.

There are two profound differences between the Russia of today and the Soviet Union of the Cold War: ideology and oil. Russia's neo-19th Century expansionist tendencies may not have been entirely vanquished, but I haven't heard a single mention of the driving force behind the Cold War: Marxism-Leninism. This was the quasi-religious ideology of the Soviet state, which called for the triumph of the proletariat and the global extinction of capitalism, a prospect which terrorized America and its allies. Nothing breeds irrational and potentially catastrophic behavior like ideological zealotry. Former president, now prime minister, Vladimir Putin may have subverted Russian democracy to his own ends, but he seems interested in power, not ideology. The Russian (and global) press avidly follows the latest exploits of Russian billionaires like Roman Abramovich. With Moscow now boasting luxury housing, upscale boutiques and expensive restaurants, you don't hear much about the working class.

With oil prices well over $100 a barrel, much of Russia's current power stems from its natural resources and accompanying wealth, not its military power. Russia supplies much of Western Europe's natural gas, which has given it far more leverage over its neighbors than its outdated arsenal of nuclear weapons ever did. If I were Putin, I'd be far more interested in the oil pipeline running through central Georgia than those unruly Ossetians ostensibly at the center of the crisis. But surely it hasn't been lost on Putin (and his hand-picked president, Dmitry Medvedev) that high oil prices depend on a healthy, stable and growing global economy, which would be threatened by further Russian adventurism.

For these reasons alone, I expect Russia to act in its rational self interest, which is to keep Georgia (and other nearby former territories) from being a thorn in its side without alienating Russia's further integration into the global capitalist economy, a process which has only enhanced Russia's standing not to mention its standard of living. Despite the hardships Russia endured during the rocky years after the collapse of the Soviet empire, it can't be lost on most Russians and their leaders that they're much better off without those money-draining, quarrelsome remnants of their former empire — what Princeton historian Stephen Kotkin has dubbed the "Trashcanistans." Does Russia really want another Chechnya on its hands? An occupied Georgia would be far worse, given what's sometimes gingerly described as the Georgian "temperament." (Recall that Stalin himself was a Georgian.)

Clearly, Putin hasn't fully learned these seemingly obvious lessons or he wouldn't have let the Russian military behave in such a heavy-handed manner, nor would he have let the affair get to the point where Russia risks economic retaliation and diplomatic isolation. He's managed to alarm even the Germans and the French, not to mention driving former satellites like Poland more firmly into the western camp. And for what? A small sliver of the Caucasus that poses no real threat to Russian interests?

The U.S. should also back away from the rhetoric of the Cold War, fanning Russian paranoia, and focus instead on what's in both countries' interests.

If Russia really wants to take what it deems its rightful place among the world's leaders, it will recognize that more than control of territory or military prowess, power today is a function of wealth. To achieve greatness, Russia must not only respect the boundaries of its neighbors, but restore the shaken confidence of investors. It needs to respect property rights, stop throwing business leaders into jail on trumped up tax charges, promote the rule of law, and treat foreign investors and business partners (like BP) (BP) fairly. None of this is a sign of weakness, but of strength.

I've never invested in Russia for these reasons, which means I missed out on a big rally in recent years. But I felt something bad would happen sooner or later. The Russia Exchange Traded Fund (RSX) is down 21% this year. If and when Russia's leadership comes to its senses, I'd love to invest. But not now. I think we will get past this crisis, but it will take years for all the damage to be undone.