Some thoughts on Ukraine, part 1

By Edward Harrison On Apr 7, 2014

It is about time I did a long-form political economy piece because a lot of what is occurring in emerging markets is of that ilk. The political economy dominates the economics of the issues in a way that makes discussing markets and economics very much related to politics. Here I want to concentrate on Ukraine because I believe it has become an important point of conflict for the future geopolitical landscape.

The frame I want to use here is the decision tree model. I may have mentioned this in the past, but it bears repeating. When I look at the political economy, a key assumption I make is that most incumbent politicians are risk-averse. And by that I mean that they have gained power and wish to maintain political incumbency by controlling outcomes to prevent outlier scenarios from taking place that put their political reign in a negative light. From a decision tree perspective this means acting in a risk averse manner by favouring conservative, status quo decisions over more risky political decisions. I believe the governance of Barack Obama, the man who came to office as “Change You Can Believe In”, is emblematic of the caution incumbency creates. Apart from Obama’s own personal attributes, this may be why he has only gone on a limb to spend potentially election-changing political capital once with the Affordable Care Act.

Another important assumption I make is that domestic political concerns are the key focus of elected politicians and most unelected ones as well. The reason is clear; voters can throw an incumbent out of office if she doesn’t abide by the ‘will of the people’ or if the domestic population sees governance as corrupt or illegitimate in some way. This is a key lesson from what happened to Viktor Yanukovych in Ukraine.

I want to start looking at Ukraine from this framing. And in particular, a recent US action in Cuba is an interesting facet that I believe illuminates how and why Ukraine is interesting and sparked my interest in writing this post. Here’s the background story. The United States’ geopolitical power reached breathtaking proportions after World War 2. With Europe and Japan indebted and weakened industrially after a long war, there was really no military/political/economic rival to the US in the capitalist world. As a result, the United States began to assert foreign policy aims that had previously been limited to Latin America in influencing foreign elections and government to become more pro-American globally. The US influence in Latin American politics is legendary and continues to this day. Case in point comes from Cuba.

The Associated Press learned that the US had secretly funded a ‘Cuban Twitter’ to stir unrest n Cuba and destabilize the government. Starting in 2010, AP writes:

the plan was to develop a bare-bones “Cuban Twitter,” using cellphone text messaging to evade Cuba’s strict control of information and its stranglehold restrictions over the Internet. In a play on Twitter, it was called ZunZuneo — slang for a Cuban hummingbird’s tweet.

Documents show the U.S. government planned to build a subscriber base through “non-controversial content”: news messages on soccer, music and hurricane updates. Later when the network reached a critical mass of subscribers, perhaps hundreds of thousands, operators would introduce political content aimed at inspiring Cubans to organize “smart mobs” — mass gatherings called at a moment’s notice that might trigger a Cuban Spring, or, as one USAID document put it, “renegotiate the balance of power between the state and society.”

The goal here was to infiltrate the political process in order to influence politics inside of Cuba in a way that favoured US aims and interests. Now, despite the democracy-focused foreign policy goals of the US, American foreign policy is also focused on bringing countries into the US sphere of influence. So, these efforts are not just about democracy but about creating a beach head for a pro-American government.

Similarly, the US has trumpeted similar US efforts in Ukraine. US Assistant Secretary of State Victoria Nuland has claimed the US has spent $5 billion in Ukraine. And while this figure seems high, the key is that official US foreign policy is to allow US government officials to highlight US efforts to influence politics in Ukraine.

From a Ukrainian incumbent’s perspective then, this represents an exogenous shock that alters the decision-tree dramatically. To the degree US efforts in Ukraine have been successful – and it does appear that leaders in Ukraine are more pro-Western than the previous government – then we can look at foreign policy as representing exogenous shocks to the domestic political economy. In pre-World War 2 terms, the exogenous shock was usually military. A politician, concerned about domestic politics, always had to be cognizant that a foreign leader could launch a military assault against his government, no matter how popular it was, and overthrow him. Today the hard power of military might is increasingly being supplanted by the soft power of initiatives like the ‘Cuban Twitter’ or the behind the scenes US activity in Ukraine.

What does all this mean for the economy? I think exogenous political shocks mean exogenous economic shocks and unpredictability. For example, was it clear in December where Ukraine was headed economically when it rejected the EU-IMF proposal in favour of the Russian one? I would say no. In fact, I would say it is only because of US influence that the protests against the corrupt Yanukovych government produced political results. Was it clear in February that Yanukovych would lose power? Again the answer has to be no because he had made an agreement to pull forward elections – which he would probably have lost. And this deal was agreed to one day, only to be cast aside the next day by Ukraine’s parliament, allowing for a unelected new government to take form, which was able to sign an EU-IMF deal within two months.

From my perspective, what we see here then is a destabilization that the Ukrainian incumbent Yanukovych did not want but that the US favoured. However, destabilization always means an increased level of unpredictability. It moves us from decision tree nodes with limited outcomes to ones with a much larger range of outcomes – many of them bad for Ukraine, the US and other actors. If you think of political decisions as yielding a set of possible political and economic outcomes, some of them good for some parties and some of them bad for those same parties, there is always a subset of options which is bad for most all parties. In a situation in which an incumbent risk-averse politician controls the agenda, those outcomes are outliers, black swans if you will. In a situation in which the incumbent loses control, those outlier situations increase in probability. Think of the distribution as having fat tails. So, due to political exogenous shock, Ukraine has moved from a more stable if unsatisfactory point with a limited range of outcomes to a less stable and less predictable point.

For example, the overthrow of the Ukrainian government led to an aggressive response from Russia, concerned about Ukraine’s geo-strategic and historic importance. This has in turn led to a secession movement in Crimea and annexation of Crimea, sanctions against Russia by the West and just today, more secession movements in eastern Ukraine. As I asked when using the Texas annexation of 1845 to think about Putin’s motives, “If Putin cannot get the unit he wants through diplomacy, could he get it by force – i.e. annexation? Perhaps in part. We do know that with the Texas annexation, war began the year after. And when the Americans defeated the Mexicans, there was the possibility of the US swallowing Mexico whole. Instead, the US worked out a deal that hived off the northern part of Mexico. An analogous outcome would be war between Russia and Ukraine with Russia taking most of eastern Ukraine that was never a part of pre-1939 Poland. The western region captured in 1939 via the Molotov-Ribbentrop Pact would remain a rump state of Ukraine including Kiev.” And so we are now seeing that this is indeed a possibility. Would we have thought it a possibility in December of February? Doubtful. Would it have been a possibility in the absence of US involvement in Ukraine? Maybe.

I believe the US involvement in Ukraine has been successful in helping to overthrow the corrupt Yanukovych government. This has destabilized the country and prompted a response from Russia which has led to a chain of events which has increased the likelihood of military confrontation. Moreover, I also believe that military confrontation would mean punitive economic sanctions, a new cold war and – as a consequence – serious economic upheaval in Europe and globally. Yes, it could all end here now, without further escalation. But further escalation is no longer an outlier event. Indeed, Angela Merkel says escalation could happen even if the present state of affairs remains. She says, “If the territorial integrity of Ukraine continues to be violated, then we will have to introduce economic sanctions.”

Financial markets are very complacent in light of these possibilities. This is not like the US debt ceiling showdown where default was an outlier possibility. Here, escalation is a high percentage possibility fully within the realm of likely outcomes. And yet, debt and equity markets are rising in developed and emerging economies. Perhaps, as with the US debt ceiling crisis, investors don’t have a good way to express caution or to hedge without it being expensive to do so. Nonetheless, I hope I have made a good case for seeing the Ukraine situation as more serious than market sentiment and direction would indicate.