US, Russia, EU, and Ukraine

In Ukraine, we're basically seeing a civil war. Eastern Ukraine consists of a mostly Russian speaking population that's, in large part, ethnically Russian. Western Ukraine speaks Ukrainian and is, ethnically Ukrainian. Seeing this divide, it makes sense why there's currently a civil war in Ukraine. There's a natural divide within the country and, quite frankly, it makes no sense for the country to exist any more.

The pro-Russian Ukrainian rebels are being funded by Putin in Russia while the current Ukrainian government is getting support from the US and the EU (colloquially called "the West"). In effect, what's going on in Ukraine is a proxy war between the Russians and the "West". This brings us to the issue of why Ukraine is important.

There's several reasons why Ukraine is important. One of the reasons Ukraine has been important in the past is because of the natural gas pipelines that run through the country. However, there's also pipelines that runs through the Gulf of Finland called the Nord Stream. On top of this, Russia in conjunction with the EU is working on the South Stream--which is a pipeline that runs through the Black Sea into Bulgaria where it's supposed to branch off to Italy in one direction and the Balkans in the other direction. In other words, the importance of the natural gas pipelines that go through Ukraine have diminished.



However, there are key weapons factories in Eastern Ukraine and it's also important to note the importance of Ukraine in control of the Black Sea (a map of the Black Sea along with current and proposed pipelines is shown above). Many important trade routes go through Ukraine and Russia doesn't have any warm water ports, which means having control over the Black Sea is extremely important for Russia. Due to these factors, Ukraine plays a critical role for the Russian national interest.

With regards to the conflict between Russia and the EU, it's important to remember that about two thirds of the Russian government's revenue came from natural gas exports in 2013. Now, there's talk of Russia even shutting off natural gas that goes through Ukraine to Europe, but it probably won't be a very large factor because of the North Stream and South Stream pipelines. There is a tail risk possibility that Russia could shut off all the gas to Europe, but the chance of that happening is, in my opinion, low (although the consequences could be huge).

It's also important to understand what's going on from a historic perspective. Ever since the fall of the Soviet Union, Russia has been (and is) at its weakest in centuries. It's important to understand that throughout its history, Russia has had to deal with European autocrats (ex. Napoleon, Hitler) that have tried to unite Europe and take over the world. Since two-thirds of the Russian population lives west of the Urals and the region of the world that ethnic Russians originated from is in modern day Ukraine (Kievyrus). The old Soviet border stretched as far west as Germany towards Berlin, which is where the Berlin wall was destroyed in 1991. Now, the Russian border is within 400 miles of Moscow. The depth of Russia that held off Hitler and Napoleon no longer exists. To really hit this point home, we must understand that the Ukrainian-Russian border lies within 100 miles of Stalingrad, which was the key battle of World War II.

So what is the role of the US in all of this? In this particular conflict we're seeing over Ukraine, the US (and the West) is the aggressor, but both sides want the Russians to look like the aggressors. Ukraine has historically been a part of Russia, the current border is within 100 miles of Stalingrad, and the Russian people actually originated from the region. So it makes perfect sense why Russia is so scared about what's happening in Ukraine. The former government of Ukraine was deposed to make way for the current, pro-West government in Ukraine. The borders of NATO have been pushed from what used to be West Germany, all the way to the Baltic countries and now there's talk about Ukraine joining NATO. It's the US and the EU that want to expand NATO to weaken Russia permanently.

What we're effectively seeing is that we're seeing a new Containment policy form against Russia. We're effectively looking at a mini-Cold war between the US and EU towards Russia. The people of Ukraine are just caught in a proxy war. The coalition the US is trying to build will probably come to include countries like Poland, the Baltics, Romania, Azerbaijan, Georgia, and other countries located near the Russian border.

With all that being said, we have a real possibility of Russia fragmenting. As I detailed in my post last week, commodity exporters are getting smashed (including the Russian Ruble). Russia is heavily reliant on commodity exports and a further slowdown in China (who, as I've discussed on previous posts, is driving commodity prices) could easily send the Russian economy in a tailspin. On top of this, the sanctions towards Russia have caused Russian production to tumble even further. The next decade or two will be very difficult for the Russian economy. If Russia doesn't rebalance its economy away from being reliant on commodity exports, we could be looking at a non-existent Russia in a decade or two.

Another realistic possibility is an intensification of war. The further weakening of the Russian economy combined with the other long term structural disadvantages of Russia (ranging from economic to geographic) could force Putin into a situation where he has to try and expand Russia's borders before the Russian economy collapses. We're already effectively seeing proxy wars, but we could see even more proxy wars across Russia's borders, including in areas like Azerbaijan and Georgia. There has also been a problem of radical Islam near the Russian border in places like Dagestan, Chechnya, and maybe even other parts like Ossetia (a map is shown below). Many of these problems are rooted in ethnic conflicts and we'll see ethnic tensions only increase as the economic situation in Russia gets worse.


A third possibility is the recreation of the old Russian empire. Putin has been working on a Eurasian Union, which is really just a code for a Russian empire. This Russian empire would effectively be an empire of nations which would include the countries Belarus and Kazakhstan while possibly including the countries Armenia, Tajikistan, Kyrgyzstan, and several other countries located in the middle of the Eurasian landmass.

The basic point I'm trying to make is that there's a lot more going on in this Ukraine conflict than just Ukraine. Really, this is a battle between the US and, as of right now, most of the EU against Russia in order to weaken Russia. This is likely to be the first in a series of conflicts that pits an alliance of various states (ex. Poland, Lithuania, Latvia, Estonia, Azerbaijan, Georgia, Germany, and a few other countries) led by the US against Russia. The rise of insurgencies and radical Islam in places like Dagestan and Chechnya combined with Russian economic weakness mean that we'll probably see an intensification of conflicts along the Russian border over the next decade or two.

Economics/Financial Consequences of Heavy Commodity Exporters and LDCs

Since the 1970's and particularly the 80's and 90's, we've seen the rise of countries like Brazil, Russia, India, China, and South Africa (the so-called BRICS). I've had a previous post on the rise of China during this period, but this post will entail the other emerging markets/less developed countries (LDCs). These countries are primarily Brazil, Russia, and South Africa (India needs to be discussed separately), but I'll also discuss other key commodity exporters like Australia and Canada.

It's important to notice that countries like Brazil, Russia, and South Africa are heavy commodity exporters. In the case of Russia, almost half of the Russian government revenue comes from natural gas exports (much of it to Europe). Countries like Brazil, South Africa, Australia, and Canada are also heavy commodity exporters. As I mentioned in my post detailing the workings of capitalism, it's common to see specialization lead to certain economies across the world that become reliant on commodity exports. Usually, we see this kind of specialization happen in countries that're either rich in natural resources or countries without proper capital inputs (or both).

In the case of Brazil, Russia, and South Africa, we've had natural resource rich countries who are still developing the capital inputs necessary in the post-industrial world of today. Keep in mind that much of the natural resource extraction that occurs in the developing world is banned in the developed world because either the extraction or refinement of certain natural resources can be extremely damaging to the environment. Developed countries often have restrictions on such kind of behavior because the risk coming from possible environmental degradation usually outweighs the short term benefits from importing those materials while these countries often have the capital inputs required for a post-industrial economy. LDC's, on the other hand, don't have those inputs while their social and political systems are often not developed enough to respond to these long term risks.

The reason I bring up countries like Australia and Canada is because of the global mining boom that's been happening. In my economic and geopolitical posts on China, I speak about how China has effectively been driving the market for commodities--particularly industrial commodities like iron ore, tin, copper, and a whole host of other metals. These raw materials are being exported from countries like Brazil, Russia, South Africa, Australia, and Canada. As China becomes forced to rebalance its economy and growth rates start to fall (as they already have), the worldwide demand for industrial commodities will fall. Iron ore prices already peaked at around $190/dry metric ton and iron ore is currently trading at around $100/dry metric ton.

This brings us to the next question: what are the consequences of falling commodity prices on these particular countries? As the prices of commodities falls, the demand to hold currencies of countries who export commodities will fall. In other words, we're likely to see the currencies of these countries (Brazil, Russia, Australia, Canada, etc.) fall in terms of foreign exchange (FX). Not only are the currencies of these countries likely to fall, but these countries are also likely to experience decreases in production stemming from a world with falling aggregate demand and falling production. So the countries in question (Australia, Russia, Canada, Brazil, and South Africa) will see input cost inflation stemming from their falling currencies while simultaneously seeing falling output and rising unemployment.

Keep in mind that many of these countries (ex. Australia, Canada) have large asset bubbles stemming from capital inflows and their currency strength over the past decade or so. These countries will have to deal with falling production and falling currencies while their asset bubbles would be bursting. On the plus side; however, Australia and Canada will experience inflation that could help prevent the real debt burden (debt/NGDP ratio) from ballooning.

I suspect that many of these countries are likely to experience stagflation or stagflation-like effects. They're likely to see falling real growth combined with input price inflation, falling output, and falling employment levels. In the case of Brazil, Russia, and South Africa, we could see significant social and political unrest.

Japan's Got Issues

In one of my previous posts, I discussed Europe's problems. In this post, I'm gonna discuss Japan's problems in a rather similar fashion. This post will be split up into eight different parts:
1. Japan's Geography
2. Japan's #1 Problem: Japan Imports All of its Food and Energy
3. Japan's Economic Model
4. Japan's Debt Problem
5. Japan's Demographics
6. Abenomics
7. What Can Japan Do?
8. Conclusion

1. Japan's Geography:
Japan is stuck on a set of islands that start in the East China Sea and touch the border of Russia from South to North). Japan consists of thousands of islands, but the four major islands of Japan are (from North to South) Hokkaido, Honshu, Shikoku, and Kyushu. As we can see in the geographical map below (left), most of these islands consist of harsh terrain that isn't hospitable to large populations (right). The small Kanto plain on the very right side (bordering the Pacific Ocean) contains the city of Tokyo and is also home to a third of the population, but notice how small the land mass is. The rest of the Japanese population is spread out in a similar manner with most of the population living on a very small space of land as most of the Japanese land mass is home to very few people.

Also note that in the geographical map above shows how most of the Japanese land mass consists of very rough and rugged terrain, which tells us that there's little arable land mass in Japan. It's also important to notice that there's little natural resources in Japan as well. So Japan has the economic problem of sustaining a relatively high population with little arable land and few natural resources. This is why Japan has, historically, gone back and forth between isolationism and imperialism. When Japan has united under strong centralized control, the result has usually ended in imperialism.


2. Japan's #1 Problem: Japan Imports Most of its Food and Energy
Due to Japan's geography, Japan is in a situation where it imports most of its food and virtually all of its energy. Before the 2011 Fukushima disaster, Japan received about a third of its energy from nuclear power. Post-Fukushima, Japan is now importing all of its energy. Japan was already importing much of its food as well and is now importing almost all of its energy. As I spoke about with China's geopolitical problems, there's serious tension between China and Japan over the natural resources (primarily oil and gas) that lie in the East China Sea.

Japan holds very little natural resources and the terrain across most of Japan is also very harsh. This is why Japan has historically alternated between periods of imperialism and periods of isolation. When Japan has come under strong centralized control, the country usually goes imperialistic and often begins to expand out into either the Korean Peninsula, Eastern China, or Manchuria (examples of time periods include the 16th century and the 20th century before World War II).

3. Japan's Economic Model:
Economically, Japan's growth model USED to be to China's current economic growth model. This culminated in extremely high growth rates in the 80's and early 90's, but also led to a massive increase in private debt and a massive asset bubble--the worst since China's asset bubble today. In the case of Japan, the Nikkei peaked near 40,000 and is still only near half of what it's peak was back in the late 80's. The Japanese Imperial Palace and the land within it was worth more than the entire state of California during this period.

The resulting crash led to a collapse of growth rates while the leadership in Tokyo decided to deal with the resulting fallout by having the public sector take on all of the bad private debts that led to the asset bubble. By taking this course of action, Tokyo rebalanced the Japanese economy over the following 20 years after the bursting of the bubble which led to the two lost decades Japan has faced. On top of this, Japan is still having difficulty growing at any significant speed while private debt has been transferred to the public sector.

Recall that the Chinese (and former Japanese) growth model works by turbocharging investment and growth by reducing the household share of income, which causes the national savings rate to go up. This forced Japan to rebalance its economy after the investment driven growth model resulted in a debt crisis. Recall that negative real lending rates were critical to the initial boom and Japan transferred resources back to the household sector by positive real lending (and interest) rates from 1990-2013. This led to a steady increase in the household share over the past two decades, but the lower growth rates resulting in the decade ending up as a "lost decade".

4. Japan's Debt Problem:
We must remember that when we think about debt, we must understand that all debt is a transfer of real resources. We must also remember that debt is created out of thin air as debt and money get created simultaneously by the banking system. All debt (and money) is, in some form or another, a claim on real resources. This means that every time debt or money is created, real resources are simply being transferred. What really matters is whether or not the productivity gains from the transfer of real resources outweighs the real debt servicing costs of the transfer. Note that the real cost of transferring real resources is the NGDP growth rate since the NGDP growth rate is the opportunity cost of not holding real assets.

Below, I've shown a chart of Japan's total debt/income ratio over the past few decades. As we can see, this prolonged deflation has actually increased the real burden of the Japanese debt. I'm also of the belief that the massive Japanese debt taken on over the past 40 years or so hasn't been used very productively. In other words, the Japanese debt burden is slowing growth because the transfer of resources hasn't (and still isn't IMO) being used productively. Japan cannot address its stagnation if it doesn't address its massive debt problem.


5. Japan's Demography:
Like much of Europe, Japan's fertility rate has been less than 2 since 1970 and has been less than 1.8 since 1974. In other words, Japan's population is rapidly aging while fertility rates continue to stay low. The Japanese workforce size peaked simultaneously with the bubble in 1990 and has been in steady decline ever since. In terms of demography, Japan was basically in the same situation in 1990 that China is in today. The workforce started to steadily decline as what became a boost to growth eventually turned into a larger and larger drag on growth. Also notice that this trend shows absolutely no signs of ebbing as fertility rates have stayed depressed.

The rapidly declining demographics doesn't just mean a drag on growth from a falling workforce, but it also means more dependents that have to be taken care of by a falling workforce. This implies larger and larger outlays into things like social security while tax revenues fall from a falling population and a falling workforce. In other words, the demographics will increase the structural budget deficit and place upward pressure on the national debt.

Basically, Japan's worsening demography makes all of their underlying problems a whole lot worse. Also note that due to Japan's rapidly aging population, we should expect to see household savings rates go negative as more people retire and pull out their savings.

6. Abenomics:
In order to fix the Japanese stagnation of the past 25 years or so, Prime Minister Shinzo Abe has laid out an economic platform that's supposed to get Japan out of its stagnation. Abenomics has three arrows and these arrows consist of:
1. Aggressive monetary policy to devalue the Yen sharply while stimulating exports
2. Fiscal stimulus involving a reduction in corporate tax rates to increase investment
3. Structural reforms

With regards to the first arrow of Abenomics, aggressive monetary policy will increase asset prices and devalue the Yen (it already has), but the impact on exporters really isn't all that clear. Recall from earlier that Japan imports almost all of its food and most of its energy. This implies that a further devaluation in the Yen would just cause a corresponding increase in food and energy costs. Although this policy of aggressive monetary easing will (and has) caused equity prices to rise while sending the Yen plunging, the result has been inflation led by a rise in input costs. Aggregate demand in nominal terms may rise as a result of this policy, but real demand will fall (and has been falling) from soaring input costs. On top of this, the people who get hurt the most from the devaluation in the Yen will be the elderly and we already discussed Japan's population.

The second arrow involves fiscal policy in a country where the real transfer of real resources caused by the massive debt is placing a heavy burden on growth. Keep in mind that none of this debt was ever written down as most of it has just kept being rolled over onto the government's balance sheet. Notice that Abenomics never deals with the debt problem and instead tries to reduce corporate tax rates in an effort to boost investment. It was these kinds of policies that created the misallocation of capital in the the late 70's and 80's in the first place and misallocating more capital doesn't fix anything. All it does is postpone the problems into the future.

The third arrow is really nonexistent. There hasn't been any structural reform--it's all been political hogwash.

7. What Can Japan Do?
The one advantage of Japan is that the Japanese government does hold a lot of different assets. The total amount of assets held by the Japanese government is about $6.6 trillion or around 130% of GDP. Japan can privatize some (or even all of these assets) in order to pay down its debt. That being said, the only problem this helps fix is the Japanese debt problem.

Japan can also try to take some natural resources that lie on the East China Sea, but there's a border dispute with China on this issue. Much of what happens depends on whether war breaks out or not. I discuss this issue in larger detail in my post on China's geopolitical problems.

8. Conclusion
Japan is in a very difficult situation both geopolitically and economically. The massive debt burden combined with a rapidly declining population represent a massive economic challenge that'll make it difficult to reverse the Japanese economic stagnation of the past 24 years while Abe and his economic program (Abenomics) don't (and can't) address the major problems.

The geographical situation of Japan doesn't help anything as Japan relies heavily on imports for key economic inputs. In order to maintain economic activity and sustain economic growth, the leadership in Tokyo will have difficulty maintaining a low cost of economic inputs for the country. In order to make sure Japan has these economic inputs, there's a real risk of war with China. However, Japan is building ties with the US and India to contain China and may very well have access to the natural resources that lie in the East China Sea.

Japan's primary advantages lie in its technological prowess and in the assets held by the national government. Japan should start privatizing some of those assets in order to pay down the debt while Japanese technology combined with US support could help Japan access many of the natural resources in its dispute with China.