Economics of the Russia-Ukraine Conflict

Russia launched a full invasion of Ukraine last night. Most of the discussion I’ve seen has naturally focused on the fighting itself- what is happening, what is likely to happen, how did it come to this.

Since there are plenty of better sources to follow about that, I’ll simply offer a few observations on the economics of the conflict:

  1. Russia is not only more than 3 times as populous as Ukraine, it also more than twice as well off on a per-capita basis. This means its overall economy is more than 6 times the size of Ukraine’s. This gap has been growing since the fall of the Soviet Union, as Russia’s per-capita GDP growth has been much stronger, while its population has shrunk much less than Ukraine’s. Putting this together, Ukraine’s measured real GDP is actually smaller than it was in 1990, while Russia’s is larger.

2. Russia’s much larger economy allows it to spend much more on its military. Russia spends $60 billion per year, the 4th most of any country (after the US, China and India). Ukraine spends only $6 billion per year on its military. So Russia is starting with a big economic advantage here, though Ukraine has some of its own advantages, like fighting on their own ground and receiving more foreign support.

3. War is bad for business. Russian stocks are down 33% in a day, their biggest-ever loss; Ukraine shut down trading entirely, and their bonds are being hit even worse than Russia’s. Regardless of which side “wins” the fight for territory, both countries will be economically worse off for years as a result of the war.

4. Russia, though, expected that the war would lead to sanctions from the West that would harm their economy, and prepared for this by building up hundreds of billions of dollars worth of foreign reserves over many years.

5. US markets are down only slightly, much less than they would be if traders thought the US would get involved directly in the fighting. But this slight overall decline conceals huge swings. Companies that do business in Ukraine or Russia are big losers. But those that compete with Russian exports see their value rising given the expected sanctions. Because Russia’s biggest exports are oil and natural gas, the value of US-based oil & gas companies is rising, while alternatives like solar are also up substantially.

6. There is still some hope for Ukraine to expel Russian troops, but its not looking good, and even a victory would involve huge costs. This leaves people all over the world wondering, how did it come to this? How might future conflicts like this be avoided? There is of course a lot to say about military preparedness, nuclear umbrellas, and ways the West can impose costs on Russia as a deterrent. But what stands out to me is that a stagnant economy and shrinking population make a country weak and vulnerable. Ukraine has a worse economic freedom score than Russia; this combined with its relative lack of natural resources explains much of the stagnation. Political elites often focus on grabbing a large share of the pie, rather than growing the pie and risk empowering domestic opponents. But we’re now seeing how stagnation carries its own risks. A growing economy, and especially growing energy sources that don’t depend on hostile nations, is the path to independence and survival.

Europe Natural Gas Shortage: Factories Shut, Maybe Worse to Come

Shut down your old reliable coal and nuclear power plants. Replace them with wind turbines. Count on natural gas fueled power plants to fill in when the breeze stops blowing. Curtail drilling for your own natural gas, and so become dependent on gas supplied by pipeline from Russia or by tankers chugging thousands of miles from the Middle East. What could possibly go wrong?

That is what Europe is discovering now as natural gas prices have quintupled, taking electricity prices up with them. Europe is having a hard time finding enough gas supply to fill up storage facilities to get them through the winter. If consumers are prioritized, widespread industry shutdowns are possible if there is a cold winter. Prices for many things will rachet up, with implications for inflations and in turn for central banks’ response to inflation. (The Fed’s Powell has been talking down the current inflation as merely transitory).

 In the UK, energy companies are going bankrupt because the wholesale price that at which they purchase gas is higher than the government-mandated cap on gas price they can charge consumers. Plants which use natural gas as a feedstock like fertilizer plants are shutting down, which impacts farmers. Carbon dioxide is a byproduct of some of these operations, and the resulting shortage of CO2 is affecting meat-packers who use it in their operations. Indeed, a food producer has warned that the Christmas dinner could be “cancelled.” That’s just how bad it is. The Brits are even delaying the shutdown of the country’s largest remaining coal-burning power plant.

Jason Bordoff of the Columbia Climate School and the Center on Global Energy Policy just published a long article giving his perspective on all this. He identifies several contributing factors:

( 1 ) Cold and hot weather affected gas consumption this year. Winter in much of the Northern Hemisphere was unusually cold earlier this year, which boosted gas demand for heating. And then a hot summer consumed more gas to make electricity for air conditioning. 

( 2 ) Other sources of electricity have been hampered. “Wind generation in Europe has been far below average this year due to long periods of less windy weather. …Demand for fossil fuels is set to spike further as Germany takes another three nuclear reactors off the grid this year as part of its nuclear shutdown. Meanwhile, drought conditions in China and South America have led to reduced hydropower output, drawing supplies of globally traded gas into those markets instead.”

( 3 ) The post-COVID economic recovery has boosted industrial demand.

( 4 ) Russia has restricted gas deliveries to Europe though the existing pipeline that runs through Ukraine. (Many observers see this as a pressure tactic to get Europe to switch over to a northern pipeline route, which would then remove the importance of Ukraine for Russian gas marketing, which would then give Russia a freer hand to resume military harassment of that country.) Also, European countries have restricted their own gas production. The Dutch are curtailing the production rate at their big Groningen gas field because local residents fear earthquakes from ground subsidence, and the Brits have restricted fracking of promising gas fields due to public protests.

As might be expected in our interconnected world, the European supply crunch has affected U.S. prices, which are at their highest level in five years. America exports gas via liquified natural gas (LNG) tankers, but U.S. gas supplies so far have not responded much to the price increase. The hostility of the Biden administration and pressure from green-leaning investors has discouraged petroleum companies from expanding drilling.

Meanwhile, California is running its own experiment in green energy  adoption:             

California, for example, is having trouble keeping the lights on as it rapidly scales the use of intermittent solar and wind power. It recently requested an emergency order from the U.S. federal government to maintain system reliability by, among other actions, allowing the state to require certain fossil fuel plants scheduled to retire to stay online and by loosening pollution restrictions. California is also proposing to build several temporary natural gas plants to avoid blackouts, even as the state shuts down the Diablo Canyon nuclear power plant, which produces more zero-carbon electricity than all the state’s wind turbines combined.

Professor Bordoff notes that “Many projections for how quickly and how much clean energy can be scaled are based on stylized models of what is technically and economically possible”, and unsurprisingly calls for policies which mitigate volatility, e.g., “…regulatory and infrastructure policies can facilitate more integration, flexibility, and interconnectedness in the energy system—from power grids to pipelines—so there are more options to pull energy supplies into a market when needed.”

Oh, and this restatement of the obvious:  

Uncertainty about the pace of transition may lead to periodic shortfalls in supply if climate action shutters traditional fossil fuel infrastructure before alternatives can pick up the slack—as may be starting to happen in some places now. And if fossil fuel supply is curbed faster than the pace at which fossil fuel demand falls, shortfalls can result in market crunches that cause prices to spike and exacerbate existing geopolitical risks. In fact, this is what the International Energy Agency just warned is happening in oil markets—a striking contrast to what it said only a few months ago, when it warned that new fossil fuel supplies would not be needed if nations were on track to achieve net-zero emissions by 2050.

Me? After working through  all this material, I’m going to go buy me some shares of ExxonMobil, the largest natural gas producer in the U.S.