Putin’s baby

What’s he up to?

Vladimir Putin has never made bones of his mission to rebuild the Soviet Union.  Early in his Kremlin career, when Western leaders were still bewitched by his soulful eyes, he proclaimed the Soviet breakup to be one of the great tragedies of the 20th century.  His foreign policies – the brutal suppression of the Chechnyan rebellion, the imposition of a customs union on Belarus and Kazakhstan, the manipulation of energy policy in Belarus and Ukraine, the protests of proposed U. S. missile bases in Poland and the Czech Republic, the invasions of Georgia and Ukraine – all make sense only when viewed as steps toward a new USSR.  We’re back in a Cold War, and Putin has the advantage.

Doubtless, the Republicans will accuse Barack Obama of “losing” Ukraine, but he had few options.  The West has been losing the ex-Soviet satellites since 1986 at least, when Ronald Reagan and Mikhail Gorbachev in Reykjavik came within a hair of eliminating nuclear weapons.  (They probably would have done it had Reagan not insisted on his “Star Wars” plan to develop an anti-missile system in space.)  They retired the intermediate-range nuclear missiles in Europe – the American Cruises and Pershings, and the Soviet SS-20s.  That reduced the probability of a catastrophic war but raised the one of a conventional war, since a belligerent no longer must worry about whether an incursion could lead to a nuclear skirmish.  In this light, NATO’s refusal to promptly accept Georgia and Ukraine as members may have contributed to Putin’s decision to invade the latter.

Exit NATO

In the Wall Street Journal, a University of Chicago professor argues that the West is overreacting to the Crimean annexation; Russia just wants protection from NATO.  This does not explain why Putin is bludgeoning some of the small ex-satellites into his ever-strengthening customs union.  Of course, he won’t object to buffers against NATO, but his primary purpose evidently is to revive Russia as a superpower.  In that sense, the West’s unkindest cut was to demote the G-8 back to the G-7.  But this is unlikely to do anything other than reinforce Putin’s resolve to get his own back.

What can the West do now?  Not much.  Western trade pacts with the former Soviet satellites may delay their entry into the new Eurasian Union (for “Eurasian,” read “Soviet”), but we’ve seen the consequences of that policy for Ukraine.  Over the long run, the US must decide whether China truly has replaced Russia as the most likely aggressor.

NATO may remain weak if stagnant Western economies can’t afford it.  Putin may succeed, since only this can retain the support of the silovikii (“strongmen”) -- the domineering military and KGB-rooted bureaucrats who seek to restore Russia to its pre-Gorby greatness.  Putin knows what happened to Nikita Khrushchev when he lost the military’s support in 1964, due to his comeuppance in the 1962 Cuban Missile Crisis.

At least the Cold War gave us a few good jokes.  In one, retold by historian Martin Walker, Brezhnev is “proudly showing his mother and daughters around his luxurious dachas, his hunting lodge at Zavidovo, his vast garage.  ‘It’s wonderful, Leonid,’” his mother mutters.  “‘But what happens if the Communists come back to power?’”  Come to think of it, maybe that’s not so funny.  –Leon Taylor tayloralmaty@gmail.com

References

Steven Erlanger.  Russian aggression puts NATO in spotlight.  New York Times.  March 18, 2014.

Martin Walker.  The Cold War: A history.  Henry Holt and Company.  1995.

Martin Walker’s Christmas list

What’s wrong with Sovietology?

The West has responded to the Russian incursion into Ukraine in a weak and confused fashion.  That’s partly because the English-language scholarship on the old Cold War is weak and confused, at least in its economic analysis.  Policymakers have nothing better to draw upon.

For example, in his well-regarded Cold War: A history, Martin Walker suggests that the Soviet Union imploded because of inefficient investment in the 1970s.  “[B]y its own doctored statistics the Soviet economy was running faster and faster to stay in the same place.  Each extra 1% in national growth required an increase of 1.4% in national investment, and an increase of 1.2% in output of raw materials.”

This claim is mystifying.  In most economies, returns to a particular input do eventually diminish.  Why must this doom the Soviet economy in particular?

Some background here may help (especially since Walker provides none).  The most common model of national output has two inputs, labor and capital.  The latter refers to the things that we produce (hammers, lathe machines, factories) in order to produce other things (furniture, autos, whirligigs).  Most fits of this model assume that a 1% increase in all inputs leads to a 1% increase in output, a result known as “constant returns to scale.”  For example, a 1% increase in capital may lift output by .7% (which is what Walker is saying); a 1% increase in labor, by .3%.  Thus the total increase in output is .7% + .3% = 1%.  One justification for this model, at least as it applies to a given industry, is that firms eventually figure out how to build a factory that produces as cheaply as possible.  To expand production, they replicate that factory.  Adding a plant to the 100 already in business – an expansion in all inputs of 1% -- will increase output by 1%.

And that may be the end of the matter, except that it’s not clear that Walker knows what he is talking about.  Journalists commonly use “capital” and “investment” interchangeably, but investment really refers to the increase in the capital stock.  In our example, the new plant is an investment that raises the capital stock from 100 plants to 101.  The distinction is worthwhile, because investment does not affect output in the same way as does the capital stock.

The saga of the last computer

To see this, let’s distinguish between two more terms that journalists interchange – “economic activity” and “economic growth.”  “Economic activity” usually means the value of the nation’s production this year; it’s gross domestic product.  “Economic growth” is an increase in economic capacity.  GDP is how much we actually produce; economic growth is how much more we can produce than before.

If Walker is really talking about the impact of investment on economic growth, then his claims are puzzling indeed.  In the usual model, investment at the margin has no impact on economic growth in the long run.  The reason is diminishing returns.  Adding the millionth computer to an office with five workers is probably not too productive.  It would make better sense to bring in computers until one more adds nothing to the office’s capacity to produce.  That happens when the new computer just replaces a worn-out one; that is, it just maintains the current stock of capital.  But economic capacity depends on the total amount of capital and labor available, so it is not affected by the investment of the last computer.

So maybe Walker is talking about GDP.  Certainly, investment will raise this: We’re producing one more computer.  But now it’s not clear why Walker is disturbed that a 1% increase in investment raises GDP by less than 1%.  After all, investment – which is the production of inputs for producers – is just one component of GDP.  We also produce for households, governments and foreigners.  Suppose, for example, that investment comprised 70% of Soviet GDP.  Then a rise of 1% in investment would raise GDP by .7% -- perhaps a bit more, if we include the subsequent rounds of spending. 

Why does any of this matter?  Because Walker seems to assume, as most Soviet scholars do, that physical capital is the key to economic growth.  For more than 60 years, statistical studies have confirmed that the growth rate depends less on the amount of inputs available than on what we know about how to use them (“technology”).  If the Soviet economy was running faster and faster to stay in the same place, then maybe its managers didn’t really know how to run.  Studies of Soviet stagnation could focus on education, training, and incentives to innovators.

And Martin Walker could treat himself to an economics textbook.  –Leon Taylor, tayloralmaty@gmail.com

                   

References

Martin Walker.  The Cold War:  A history.  Henry Holt and Company.  1995.

Lame game

Can the West forestall an invasion of Ukraine?

As Russian troops mass on the eastern border of Ukraine, the United States and Europe ponder options to prevent an invasion.  How should they analyze these options?

Economists suggest this:  Given the option chosen by one player, determine the best response by the second.  This is “game theory” – a name guaranteed to bring undergraduates flocking into the classroom.

Our two players are Russia and the West.  Each has two options.  Russia can either invade or do nothing; the West can either impose sanctions or do nothing.  If the West does nothing, how will Russia respond?

Of course, Putin will invade.  Annexing eastern Ukraine is popular in Russia.  If it would cost him nothing, why not give the troops the green light?    

And…if the West imposes sanctions?  The response depends on the sanctions.  The West says it will begin by blocking foreign travel by low-level bureaucrats in the Kremlin.  If anything, this policy is more likely to induce an invasion than had the West sat on its hands.  A travel ban is easy to reverse, and it costs the West nothing.  Thus it signals that the West cares too little about an impending invasion to fight it with measures that it will find painful.  Had the West simply said it would do nothing at present, this at least could have reserved the possibility of doing something serious later.

Plugging the pipelines

A more effective option is to boycott Russian oil and gas.  Since Europe, especially Germany, relies on the Russians for much of its energy fuel, it would suffer from a boycott – signaling the Kremlin that it takes an invasion seriously.

Yet announcement of a boycott is also unlikely to stop an invasion, because the West cannot convince Putin that it will stick to the sanction no matter what.  If Putin invades, then the payoff to the West of a boycott will diminish, for two reasons.  First, the effects of an invasion will be difficult to reverse; Putin cannot just hand back eastern Ukraine to Kiev and tell it to never mind.  Also, a boycott over time will become more agonizing for Europeans, since it increases their energy costs and chances of recession.  Consequently, once the invasion occurs, the optimal response for the West is to end the boycott.  The Kremlin knows this, so it will not take the threat of a boycott seriously.

Some Western diplomats argue that a boycott can work against Russia because it worked against South Africa and possibly Iran.  But this situation is different.  Regarding South Africa, it was clear that the West would continue sanctions until Johannesburg had abandoned apartheid.  Continued sanctions were credible because their payoff to the West didn’t change much over time.  Consequently, if they were worth trying in the beginning, then they were worth continuing a few years later.  Thus Johannesburg could easily believe that the boycott would continue.  But regarding Russia, the payoff to the West of a boycott would be smaller after the invasion than before it.  It’s not a credible threat.

In short, no matter what the West does, Putin’s best response is to invade.  Given this, the optimal response for the West (optimal in the short run, anyway) is to threaten a boycott (for purposes of publicity) until the invasion occurs – and then quietly drop it.

The problem is that the West lacks options.  Had it been able to threaten to use the military, then Putin might have thought twice.  Without that option, the West’s best hope is to somehow convince him that it will continue a boycott after any invasion.  Or it could offer him a carrot not to invade, but that could motivate him to threaten more invasions in the future, in order to collect more carrots.  Welcome to the peace dividend.  –Leon Taylor tayloralmaty@gmail.com

Good reading

Tyler Cowen.  Crimea through a game-theory lens.   New York Times.  March 15, 2014.

       

Thomas C. Schelling.  Arms and influence.  Yale University Press.  2008.

The crystal ball drenched in oil

The fall of the pro-Russian government in Ukraine has led to a threatened secession by the Crimea region and to tension in eastern Ukraine; both regions are dominated by Russian speakers.  How might this crisis affect the foreign exchange value of the ruble, the euro, the dollar, and the tenge?

Here’s my two-cents’ worth (which you should discount for inflation):

Ruble.  In the short run, uncertainty over the impact of economic sanctions on Russia will reduce the demand to hold the ruble.  There are safer currencies now to stuff into your pillowcase (or your bank account, if you trust your bank).  The ruble will weaken now, but what will happen to it over the long run is less clear.  If Russia can acquire Ukrainian territory without permanent damage to its own economy, then the ruble will eventually strengthen beyond its pre-crisis value.

Dollar.  For similar reasons, the dollar will strengthen now.  Economically, the United States has less at stake in the Ukrainian conflict than do Russia and Europe.  Demand to hold the dollar, rather than the ruble or the euro, will increase.

Tenge.  This will strengthen in the short run.  Sanctions may reduce world demand for Russian oil and thus increase demand for crude from alternative sources such as Kazakhstan.  Even if Europe does not buy more oil than before from us, its increased demand for non-Russian oil will raise the price of crude and consequently raise global demand for Kazakhstani oil when it has become cheaper than before relative to oil of other suppliers (bearing transport costs in mind).

Some economists argue that since the price of oil is expressed in dollars in the global market, changes in that market don’t affect the tenge.  The arguemnt overlooks the fact that when demand increases for Kazakhstani oil, it also increases for Kazakhstani oil inputs.  The owners of that labor and capital must be paid in tenge.

Appreciation of the tenge would endanger the few dregs of credibility remaining to the National Bank of Kazakhstan, which devalued the tenge by about 20% just a month ago.  To be fair, I must say that Bank officials could not have anticipated an incipient civil war in Ukraine at that time, particularly since they don’t seem to read the newspapers.

Euro.  Europe was on the verge of a weak recovery when push came to shove in Kiev.  If Europe pursues sanctions, then its energy costs will rise, since it must buy oil and gas from sources that are more expensive than Russia.  This could raise production costs, leading to a fall in output, a rise in unemployment, and an overall rise in prices – a triple-whammy known as stagflation.  To say the least, the euro will weaken. 

Alll prices are relative, and the exchange rate – which is the foreign price of our currency – is no exception.  The predictions here of appreciation or depreciation in a given currency are with respect to a currency unaffected by the Ukrainian conflict (the Thai baht?).  Still, let’s look at some exchange rates for just the four currencies discussed here.

For the short run, the safest bets are: 

(1)  The number of dollars per euro (or ruble) will fall.  That is, the dollar will strengthen.

(2)  The number of tenge per euro (or ruble) will fall.

It is not clear what will happen to the number of tenge per dollar (although it seems to be falling at present) or the number of rubles per euro.  It’s hard to wipe clean a crystal ball of all that oil.  --Leon Taylor tayloralmaty@gmail.com

 

Notes

1.  I thank, but do not implicate, Dmitriy Belyanin and Yerkin Omirzak for discussions.