This Is Worse (Because I've Already Had a Post in the Last 4 Months Called 'This Is Bad')

 

I had connectivity problems. Wrote this Monday and Tuesday but just getting it posted today.

***

A couple of days ago something happened to the Nord Stream 1 and 2 gas pipelines.

Today they are saying it must have been sabotage. A few people are saying it is an act of war (not me).

***

You may have noticed that the war in Ukraine has had a lot of macroeconomic repercussions. This is an upgrade to that stress level. I don't really want to post about military geopolitics for a macro class, but this is what we've got in 2022.

*** 

You've no doubt gathered that Russia produces a lot of natural gas, which is piped to western Europeans. For gas, pipelines are a lot more economical than ships.

There are a number of pipelines doing this. Nord Stream (now called 1) and Nord Stream 2 are a couple of them. Nord Stream 1 is operational, but has been shut down since mid-summer. The Russians claim this is for maintenance, but few believe them: it's more of a bargaining position. Nord Stream 2 is not operational yet, and progress on it was stopped by Germany after Russia invaded Ukraine. But it was pretty close to ready to go when the war started.

Both run along the bottom of the Baltic Sea. Naive people worry about putting pipelines on the bottom of the ocean. Don't. This is safer: away from people, out of harms way, and well-insulated from the rest of the world. Pipelines routinely last several decades without much maintenance or leaks on the ocean floor. And they're probably way more common than you'd guess.

These are big infrastructure projects. Costs are estimated at $15B (not sure if that is for one or both). Each pipeline's underwater part is about 800 miles long, the pipes are steel, 4 feet in diameter, and 1-2 inches thick, with a 4 inch coating of concrete around the whole thing (tweak the recipe a bit, and it's not hard to make concrete that really resistant to salt water).

They are mostly debt-financed by western bank syndicates. They are owned by the Russian company Gazprom through their German subsidiaries.

Potential revenue from these is highly volatile due to volatile natural gas prices, but $20B/yr is a reasonable estimate right now. Note that this is revenue not profits, so figure a few billion in profits in a good year.

One could also estimate that if a big fraction of the $15B cost was financed with debt, that interest payments are in the $2B/yr range due to risk. Those payments have to be made whether the gas is flowing or not (and the Russians have been pretty good this year about making payments on their debts to western banks).

***

Sunday night, starting about 6 pm, when it was the middle of the night in the Baltic Sea, 3 4 events took place along the 2 parallel pipelines, in international waters, at different times, in a region where the pipelines are actually a few miles apart.

These were recorded by seismometers, and appear to be substantial explosions. Estimates are for the equivalent of at least 100 and probably 200 Kg of TNT.

N.B. These were not natural occurrences. Natural gas doesn't burn (or explode) under water. (It can form fireballs when it hits the surface).

During the day, Danish planes found a bubble field on the surface of the ocean about a kilometer in diameter. Neither pipeline is running, but they do contain some gas in them as routine.

***

This is an act of terror, but terrorists seem unlikely.

These pipelines are 200 feet deep. Despite what you see in movies, working at this depth is expensive and rare. It takes ships, submersibles, but probably not divers. But bottom line it takes money.

The pipelines are steel and 1-2 inches thick (remember they are under pressure), so this is in the range of medium armored military vehicles like armored personnel carriers. Bottom line, explosives won't budge these. You need armor piercing or shaped charge munitions.

You can't really "shoot" anything at that depth either, other than an actual torpedo with a homing mechanism. That seems unlikely because they leave wreckage.

In addition, it seems odd but not that surprising when you think about it, but metal reflects explosive shock waves. Not completely to be sure, but partially. And curved metal does an even better job at reflecting damaging shock waves. Shaped charges are used for this: the explosive is packed around a metal cylinder that liquifies, and cuts straight through the steel due to pressure and heat. Things like this are not the stuff terrorists make in the kitchen with a few household chemicals.

I also learned today that anyone doing this would have to get quite far away before setting off the devices. This is because the escaping gas would upset the buoyancy of any vessel with a mile or two.

So, speculation is a submarine or submersible, using unmanned vehicles, to attach specialized charges in multiple spots, that cruised away and detonated from a safe distance.

But once you admit to that scenario is likely, then it's also possible that the charges were set a long time ago, and someone just waited for an opportune time to hit the switch. 

Another possibility is that the Russians did this by sending a "pig" down the pipeline with a bomb attached. A "pig" is a robot that checks the interior of the pipe for damage. Not hard to load it up with a bomb ... and most things are easier to damage from an explosion on the inside going out rather than from the outside going in.

On Wednesday, a German publication reported that German security officials believe both pipelines have irreparable damage.

***

Who has the capability of doing this? 

The United States. Russia. That's the short list.

The medium list would include the UK, France, presumably China, possibly Israel, possibly richer more militant oil states like Saudi Arabia, and Iran ... and that's about it.

It is not clear if Ukraine has this capability at all. Of course, they've been getting cool new military hardware for months, and they seem willing to use what they've got. But submarines?

It's definitely possible that some other countries — Germany, Poland, Japan, South Korea, maybe others — could probably cobble together all the different pieces required to pull this off.  

It is also remotely possible that this is industrial espionage. Could a rogue actor in a pipeline company do something like this? Maybe. Shaped explosives aren't just used in the military. They'd have submersibles. They'd know where the sensitive spots are. But the motive is hard to come up with. Insurance fraud? Some Bond-worthy fantasy about driving up natural gas prices?

Could it have been environmental monkey-wrenchers? The scale of the attack would seem to preclude that.

***

Who would benefit and who would be harmed?

This is not straightforward at all. In part, this is why this is such a big deal.

First off, this is a provocation more than an attack. No one was hurt. Nothing visible was wrecked. The pipelines weren't running. But they have been a center of controversy all year.

Certainly the syndicate of western lenders is harmed: they volunteered to turn their financial wealth into a physical asset on the promise of getting a steady stream of payment checks. No doubt they are insured, but acts of war, terrorism, and industrial espionage are usually not covered.

A key here may be that the Russians won't be harmed much by this. Their gas wasn't moving through the pipelines. If anything, they'd probably like them open and running. But (aha) they weren't the ones who closed them. In short, the value of the pipelines to Russia was taken away, and with it their incentive to leave them unharmed.

I'm projecting here, but this all sounds like an escalating criminal spat. The Russians get belligerent. The Germans say "Hah, we'll just close down the second pipeline". Then the Russians say "Nice pipelines you have there. It would be a shame if something were to happen to them." And then something did.

If this is the case, sabotaging the pipeline is a way of boxing in western Europeans (mainly Germany). You had this bargaining chip. And now you don't.

I also think it's reasonable to think that the Russian company that owes interest payments on the pipelines, and has no cash flow from them, could claim force majeure if they can keep their hands clean, and get out of future payments.

Another interesting theory is that Putin is losing. He probably can't lose to Ukraine and stay in power. But, could he tweak NATO enough that Russia backs down, and declares a ceasefire? Putin might come out of this smelling like roses in that situation.

Who would be threatened most by this sort of attack. Actually, it's probably not the users of Russian gas. Instead, it's the alternative suppliers of gas to western Europe who use underwater pipelines. That would be Norway and the UK. Perhaps the signal is for them.

The German government might have motive here too. They cut off the gas for political reasons. But their public doesn't like that, and is willing to throw Ukraine under the bus to get Russian gas. In fact, there were big protests in Germany last week to open Nord Stream 2 and get the gas flowing again. If the pipelines are blown, then no more domestic political problem. Hmmm.

Lastly, Schelling won a Nobel Prize in 2005 for working out the theory of how destroying your own options pro-actively can make your other bargaining chips more valuable. Maybe this is what Putin is doing: cutting his own options.

***

Uh-oh. Turns out the CIA warned the Germans about a threat of sabotage to the pipelines a couple of months ago. Wonder what they knew?

And President Biden made a veiled threat that we could and would shut those pipelines down if needed. When this first came out on Tuesday, I think most people thought it was just blowhard Joe mouthing off again. But today it surfaces that an Undersecretary of State made a similar threat a few months back. Both of those were in official statements, video of which is easy to find on the internet.

And then there's the accusation. Almost immediately a Polish politician declared on Twitter that the U.S. were the only ones with both incentive and capability to do this. News articles are dismissive of him: characterizing him as a former defense minister. Wow. This is possibly propaganda on our part. The guy is not just a former defense minister (2 years). He was also foreign minister (7 years), a member of their parliament, then the analog of our Speaker of the House of Representatives (currently Nancy Pelosi), and then he got elected to the European Parliament in Brussels where he's still serving. This is all publicly known, but I have yet to see an American media outlet note any of it. Basically, he's not a crank. Oh ... and he worked in DC for a couple of years recently at a major market-oriented think tank. And oh ... he's married to Anne Applebaum, a well-known historian of 20th century Eastern European history, who currently has a column published in most issues of The Atlantic. In short, the guy is dialed in, and was on top of this right away. Maybe he knows something.

And if that's the case, perhaps it was the CIA saying "Nice pipeline you've got there. It would a shame if something were to happen to it.".

There's an interesting clue that might support this. Intel sites on Twitter have posted radar tracks of both American and German surveillance planes over the pipelines at the time of the explosions. Hmmm.

In my heart, I don't really believe this section. But as a professor, do I have to tell students that we shouldn't be emotional and dismiss this too quickly? Yes.

China Coup Rumors Update

Xi made a public appearance today, so no successful coup. 

But if there's no fire, there's still smoke: air traffic is still severely curtailed across northern China.

My guess is that 1) Xi caught COVID-19 in Uzbekistan, left early, and went into quarantine for 10 days, and 2) Chinese intelligence has heard rumors that scare them about air travel and the upcoming 20th party congress which begins 2 weeks from Sunday.

China Coup Rumors

Something is going on in China, the world's second biggest (or maybe biggest) economy.

No one is sure what. It's definitely something.

But it's all rumors, and they seem a little overblown. And they are definitely being fanned by influences in India (not a friend of China).

Specifically, the rumors are that Xi Jinping is under house arrest.

Factually, here's what we know. Xi attended the Shanghai Cooperation Organization meeting in Samarkand (Uzbekistan).† But he left early. After returning to China, he has not been seen in public or on Zoom. He got back 10 days ago. There was a meeting of a defense organization that Xi heads; he was not there, but a general that everyone thought was purged 2 weeks ago ... was. 

And here' the weirdest thing: commercial air traffic in the northern half of China has been mostly shut down for 5 days now. I am watching Beijing Capital International Airport on flightradar24.com right now, and it shows 12 planes in the entire region, and only 4 at gates. (Now, it's not a big airport even for China, but it's comparable to Sea-Tac or Houston Bush in the U.S.). And, it's 9 am on Monday in Beijing right now: prime time for departures. I am looking at Sea-Tac, where it's 7 pm on a Sunday, and the planes on the ground are so dense I can't count them, and the planes in the air alone outnumber all the planes in the Beijing region. (Yes, I am using the same scale on the map).

On the pro-Xi side, an official publication of the Chinese Communist Party (CCP) released a list of attendees at a big upcoming conference and Xi's name was on the list. That conference is huge. It's the 20th National Congress (held every 5th year) of the CCP. At it, Xi was expected to be confirmed for an unprecedented third term (although he has made it clear before that his plan is to be in charge for life, this would be a stamp of approval for that).

† The Shanghai Cooperation Organization (or SCO) is a group China has formed of important countries with underdeveloped economies in opposition to western, developed, country interests.

Hat tip to my son Ben.

Kaliningrad Update

Been busy. Summer. Enough said.

***

Cooler heads have prevailed in the Kaliningrad situation.

Officially, the first train in 6 weeks, from Russia to the Kaliningrad Oblast, transiting Lithuania, arrived this week.

Unofficially, that sort of transit has been in the works for about a month. So things actually stayed fairly calm throughout.

Initially, the EU said a list of goods were sanctioned, and could not be shipped to Kaliningrad. Ostensibly, this was all military stuff. Realistically that included anything that might be used by military forces ... so just about everything.

One of the sanctioned goods was cement.† Because you could use cement to make concrete for fortifications. Of course, cement has a lot of other uses too, so the Russians made a point of sending a train full of cement through first.

I think the bottom line(s) of all of this is are: 1) the Russians have shown a willingness to use military force, 2) the EU has not shown a willingness to use military force, 3) the EU tries to use macroeconomic force to influence Russia, 4) they're either not very good at that, compromised, or feckless (a good vocabulary word for any college student to learn), and 5) the Suwalki Gap still exists and may be a festering problem.

† Cement is surprisingly important in trade: it's one of the top (volume or weight, but not value) items in international shipping. A lot of students don't understand what cement is: it's the dry stuff you mix with (local) water, and (local) aggregate (mostly stones or pebbles) to make concrete. For an economics student, cement production has high fixed costs: that implies it's made in huge quantities by a smaller number of enterprises. So, making cement at a big plant in the main part of Russia, and shipping it to an outlying oblast makes sense.

This Is Bad: Lithuania, Russia, Kaliningrad, the Suwalki Gap, the Feckless EU, and NATO

There's a lot to unpack here. There is some macroeconomics, but most of the unpacking is politics, history, and revanchism. The legacy media isn't paying much attention to this yet, but the internet is just starting to notice the implications (here's articles at ZeroHedge and Politico). They both lack some background which I'll summarize here (this possibility has not been invisible on the internet for several years, but it's been pretty minor and speculative).

The macroeconomics is that over last weekend Lithuania announced that it would be blockading the transport of certain Russian goods across its territory. 

Blockades are not overt acts of war, but if the blockaded country counters militarily it's typically viewed as justifiable. A blockade is a provocation.

A big difference here is that Lithuania is a member of NATO and the EU, and Ukraine is not and was not.

At its core, NATO has a treaty. In that treaty is Article 5. It states that an attack on one member country must be defended by all other members.

The lame response of many European states to Russia's attack on Ukraine has been justified because Article 5 does not apply to that situation. How will it play out if NATO, through Lithuania, provokes Russia, and Article 5 gets tested? That's the political problem.

Let's unpack.

Trigger warning: I'm not trying to unpack my prejudices here; rather I'm trying to clue you in to why other regions' peoples might see themselves as different and act upon that. This is missing from the two articles linked above.

***

Whether we like it or not, we can understand a lot about what's going on by thinking about countries, nations, and states. 

A country is the physical thing on a map, with flags, borders, signs, and so on to tell you where you are.

A nation is a set of people with some collective identity, often centered around language, religion, other aspects of culture (but let's face it, those are the big two), and shared history.

A state is a government that runs things in a certain region. A state that controls more than one nation, but is mostly run by one of them, is an empire.

Geopolitics works most smoothly when a country, nation, and state roughly coincide. The country and nation cover the same region, and the state is organized and powerful enough to keep the whole thing together. Think ... France, Japan, or even Egypt or Jamaica.

***

Russia (and the Soviet Union) were empires that controlled some of Ukraine for 300 years and all of it for two hundred.

This was not too bad as far as empires go, since Russia and Ukraine share a religion, and their languages are both Slavic. The Slavic language group is divided into three parts: eastern, western, and southern, and both Russian and Ukrainian are from the eastern group. You might think of them as siblings, and an analogy to this case might be if France had an empire and controlled Spain (closely related languages, shared religion). Could they make that work? Maybe so (and they did for a decade here and there in the 18th and 19th centuries).

But, when the Soviet Union broke up, Ukraine went its own way (Lithuania too, more on that below). Some in Russia weren't happy about this (that's irredentism, which is different from, but often goes along with revanchism).

And the casus belli used for the war is that part of the nation of Russians was contained in the country of Ukraine, and the state of Ukraine wasn't being nice to them.

***

The western Slavic speaking nations are more like Russia's cousins. The language isn't as close. Further, they're mostly of a different religion (Roman Catholic vs Eastern Orthodox).

This is Poland, Slovakia, and Czechia, and these are some of most active opponents of the Russian invasion of Ukraine. 

Only Poland was part of the Russian empire (and only partially), and while not part of the Soviet empire initially, the Soviets took some Polish territory during World War II, and all three were certainly dominated by the Soviets for about 2 generations. 

They have reason to worry.

An analogy for this relationship is if France tried to control England. As recently as 125 years ago these countries were enemies, they fought the last time 200 years ago, and they've problems go back to the 11th century.

If you've ever noticed historical and cultural friction between the English and the French, it's worse between the west Slavs and the Russians.

***

How does Lithuania fit into all this?

The Lithuanians, while sandwiched right in between the east and west Slavs ... aren't Slavs at all. They're Balts.

What's a Balt? Within the European part of the Indo-European language group there are 7 groups. Three of those are big (one is the Slavs, while English is in a separate group), and four of them are small, including the Celts, Greeks, Albanians ... and Balts. 

Further, Lithuanians tend to be Roman Catholic, unlike the Russians to their east.

To continue the analogy, Ukraine might be a sibling of Russia (that they don't get along with), Poland a cousin (that they're barely on speaking terms with), and Lithuania ... merely a neighbor (that they mostly ignore but are willing to be hostile towards if necessary).

***

I wrote that there's a lot to unpack, and it's not done yet. Now we have to talk about the Germans.

In the 4th century, the Germans ... (the barbarians who were going to invade the Roman Empire) occupied lands going as far east as Ukraine. Note that this is ALL the Germans that end up spreading stuff like blond hair, blue eyes, tallness, and even limited government across most of Europe. The Germans we think of today are just the ones who stayed in what we now call Germany. Or more correctly, what Germany looked like around 1900 (that map isn't great, but it's simple and free).

They had raided to the west and south for hundreds of years, and we know this because the Romans kept decent written records. Maybe they raided to the east too, but we have no records of this.

Anyway, in the 4th century they start migrating west and south, rather than just raiding. 

Behind them come a number of other ethnic groups. Amongst those are the Slavs, and the west and south Slavs are where they still are by perhaps 700 AD, and it seems like the east Slavs may not have moved at all. Interestingly, the west Slavs were quite a bit further west then than they are now (some of them even assimilated with the Germans).

Christian missionary work, conversion, and conquest, are also going on at this time. In the next couple of hundred years, that gets kind of settled: the west Slavs become Catholic, the east Slavs Eastern Orthodox, and the south Slavs are a mix.

Now, maybe they were doing this all along, or maybe it was something new, but the Germans start pushing back and migrating in small numbers back into Slav territory about a thousand years ago (FWIW: all that stuff Hitler said about lebensraum was not new, and may have resonated well because it was more of a tradition). I don't have a date for this map, but I'd guess that it is circa 1925 — anyway, the dark red areas are where they speak German and you can see that they're dotted all over areas of eastern Europe that no one ever thought of as Germany.

And it gets very little attention in European history classes these days, but part of that was honest-to-god Crusades against the pagans. These started up about 50 years after the First Crusade hit the Middle East, but they were fundamentally the same thing. The most important of these ran from the 12th through the 14th centuries along the south coast of the Baltic Sea against that last pagans in Europe: the Balts (less impressive Crusades also went into Romania). 

Eventually the Balts were converted, but what's more important for this post is that they were mostly shoved out of some of their lands. Germans settled there. The kingdom they established was called Prussia.

Even casual students in high school history classes learn that the Germans weren't united as Germany until fairly recently. That starts with Prussia merging with another country called Brandenburg in the late 17th century (keeping the name Prussia, and the culture, but shifting their center further west towards Berlin). It finished with a united Germany in 1871, that had just beat up three of its neighbors, and began sulking off towards the two world wars.

Video games and pop-historical fiction make a big stink about the Templars (probably mostly because if you're gone they can say whatever they want about you, including that you might just be hiding). But more important historically are the Teutonic Knights: a religious military order, founded by Crusaders in the Middle East, within the affinity group of German-speakers there, who then went and crusaded in northeastern Europe, founded their own kingdom, and left behind a militaristic culture that came to dominate Germany. They don't cover this in video games and movies because it happened for real, and it was not fun.

The center of this was a city named Konigsberg. It was surrounded by a rural area known for its forests, lakes, and grain farming. On maps of Germany from before World War I it's that part that stick out at the top right, and in maps from after World War I it's that blob of Germany that's separated by a sliver of Poland.

Oh ... and as the Prussians settled down a bit and reconnected with their fellow Germans to the west, the Russians moved in and conquered the Balts in the 18th century.

Still with me?

***

You may have heard the eastern front was a pretty big deal in World War II. 

World War I too ... although in that war the Germans won on the eastern front. And took most of what is today Poland, the Baltic countries, and Ukraine from Russia (pretty much anything where there were a handful of German speakers in that map linked several paragraphs up).

That showed their intent. Reality intruded and they weren't allowed to keep those lands. 

But you can imagine that this did not make the Russians/Soviets happy when there Nazis invaded in 1941.

On top of that add the genocidal policies of the Nazis towards what have been called the bloodlands, and the separate genocidal policies of Stalin's Soviets towards those same regions.

The name we use for all policies of this sort today is ethnic cleansing.

What later happened on the eastern front was that as the Soviets started to rout the Nazis from mid-summer of 1943 onward, they did some pretty serious ethnic cleansing of their own. This was not just against Germans, but if you were German and the Soviets were coming, you fled to the west (estimates are that there were 12 million German refugees).

The largest concentration of those were from the original Prussia. With the Germans out, but the cities and farms sort of intact, the Soviets moved Russians in to the best parts, and let the Poles have part of it too.

That best part included Konigsberg. The Soviets wanted this because Russia has always lacked for ports that are ice-free year round. Konigsberg isn't great for this, but it was an improvement over what they had. They renamed it Kaliningrad. (Note that a lot of places in Russia went back to their traditional names after the Soviet Union collapsed, but not Kaliningrad ... probably because any Germans that might have wanted it to be called Konigsberg had started new lives in other parts of the world 50 years beforehand).

Oh, and, ice-free port, and closest to the west, Kaliningrad became a hugely important military outpost for the Soviets ... probably full of loyal Russians who'd been given homes and land for free. It was and is widely believed that nuclear weapons have been stationed there for decades.

In short, Kaliningrad is part of the country, nation, and state of Russian ... even though it is not contiguous with the rest of it (because there's a country, nation, and state called Lithuania in between).

***

Now, at this time there were still true believers in the communist system running the USSR. And we don't think about this much these days, but they did kinda' sorta' respect ethnic divisions. 

They did this because they thought the major divisions between people were about class and not about ethnicity (oops!, that one came back to bite them).

But at that time as long as you formed a soviet system (based on councils of workers), and accepted that even though there weren't supposed to be any dominant ethnic groups but the Russians really were it, you could have some modicum of independence within the USSR (that's why it was called the Union of Soviet Socialist Republics).

So in 1991, there was a Lithuanian SSR and a Ukrainian SSR, and twelve others, all ready to go out on their own when given the chance. And the biggest one was the Russian SSR, which is the huge blob of Russia you see on maps. 

Included in that was the strategically important, and for the last 40 years heavily Russian enclave of Kaliningrad.

Except that it was separated from the rest of Russian by Belarus and Lithuania. Belarus is friendly towards Putin, but Lithuania is scared to death of him (remember, they're neighbors but not family). And they were accepted into NATO and the EU to send a "hands off" signal to Russia.

No one thought this would be much of a problem in the 1990's because the Cold War was over, and Russia was going to play nice with its neighbors now. 

There was even a book that dominated intellectual discussions at the time called The End of History and the Last Man by Francis Fukuyama. It's thesis was that humans could pretty much forget about most of what I've written above here because it wasn't going to matter any more. 

Doh!

***

OK. The background is all done. 

What happened this week?

A few months back I posted about the problem of Transnistria in the Ukraine-Russia war. Transnistria is the part of Moldova that wants back into Russia, and is a problem because it's not connected to Russia.

Kaliningrad is Transnistria on steroids. Transnistria isn't Russian and was never a part of Russia. Kaliningrad is both.

And the feckless EU is going to blockade certain Russian goods, and the Lithuanians stated they will enforce it. 

But this means they will be enforcing it in a place and way that the Russians may take extreme offense with. Oh ... and like Ukraine, there's a Russian minority in Lithuania that they can claim is being mistreated (no doubt, mistreated the worst right along the rail air corridor heading towards Kaliningrad, right?).

All Russian internal commerce with Kaliningrad either goes through Lithuania (by train), or through Poland (by road), or both through the air. Poland is even more militant than Lithuania, but the Russian can probably put up with them because they no longer share a border with them. Russia does share a border with Lithuania.

The region in question is called the Suwalki Gap (after the largest city in the region, on the Polish side). The president of Estonia named this in 2015, and pointed out that this could be the flash point for a putative World War 3. 

Russia has demanded that Lithuania lift the blockade. There was panic buying in stores in Kaliningrad last weekend. 

Kaliningrad governor Anton Alikhanov says that the ban, which was confirmed on Friday, affects roughly 50% of all imports.

Currently Russia is ferrying goods from St. Petersburg down to Kaliningrad. 

***

So it's all pretty simple. Macroeconomically there's a blockade going on. Politically it might start World War III because it might be a much bigger deal than just Russia and Ukraine.

Stay tuned.

***

P.S. If you're a student of military history, the Suwalki gap is just east of the two big battlefields where the Germans defeated the Russians in 1914, and is the area where they fought a major battle in early 1915.

Remember When I Wrote About that Container Ship Full of Toxic Waste from Burned Electric Cars, and I Said It Would Be Forgotten Because It Sank In International Waters??

The BBC, which last I checked prided itself on being a fairly comprehensive new service, published an article entitled "How to Rescue the World's Biggest Cargo Ships" (ungated version available here). It has 399 hits on Google already.

It makes zero mention of the Felicity Ace fire, abandonment, and sinking. I covered that extensively in February 2022 until the final post about it on March 1. But it did spend a lot of time on 3 other ship losses that were further back in time and further away distance-wise from where the author was presumably working in London.

***

Being in international waters far from posh restaurants, entertaining bars, and free wifi, makes it easy to ignore.

Being filled with tons of flammable electric vehicles full of hazardous waste make it desirable to ignore.

P.S. Due note that if you're going to have an environmental disaster, it is better to have it out in the salt water, away from humans on land and the fresh water sources we depend on.

Xi and China Rumors

Hmmm ...

I do cruise some sites that are sketchy at best ... so no links from them here.

But there is some scuttlebutt floating around that Xi Jinping may be in trouble, and/or that there may have already been a sort of friendly takeover.

***

Certainly things are pretty weird in China.

We're now into a third month of severe lockdown blamed on COVID-19. I don't find the zero tolerance story implausible. But I'm starting to worry about the macroeconomic damage. We saw what happened in the U.S. when we shut down for what amounted to about 7 weeks. In what world does that much damage to China make sense, given that we know a lot more about the disease now than we did 2 years ago.

Also, the lockdowns are in major political and economic centers: Shenzen? Shanghai?? Beijing??? 

They also arrested a 90 year old Catholic cardinal in Hong Kong the other day. I don't care what he did ... if he was a mass murderer it would still be pretty weird to arrest someone that age, publicly.

Then there is the public resurgence of Li Keiqang. He was sidelined for 9 years. Now he's back? I posted a couple of months ago that he was being pushed into retirement.

Something's up.

Shout Out to DR

Former student DR is still reading. Good for you, and cool to run into you today.

One of the Oddest Posts I've Ever Written (Not Required)

SE was in one of my principles sessions during Fall 2020. It was on Zoom. A lot of you were in those Zoom classes: TB, EC, BH, AH, TH, IP, BU, AW, CY (and probably others I can't recall).

He asked a question on 11/24/20 through chat rather than audio. I saw it, but thought it took some extra consideration, and told him I'd answer it later on.

So I took a screen capture, and promptly lost the image somewhere on my hard drive.

And would you believe I've felt bad about that ever since? I can even remember telling him as that semester wound down that I'd answer that question, while covering up for the fact that I couldn't find it, and hoping that I would.

***

There's a wicked search tool you should all have on your PC's. It's called Everything, it's made by VoidTools, and it's freeware. (Ninite also has it, if you use that service).

While searching for something with the word emblem in it on Saturday, I got halfway through the word, and up in my search results popped an image with SE's last name.

I opened it up, and there was his missing question from 17 months ago.

***

Now I feel obligated to answer it. We were doing comparative advantage examples, and he asked:

I'm not sure I quite understand the question anymore. But here goes.

First, in the real world that whole "whoever can produce more" goes right out. Small countries do get comparative advantages, and they do specialize in them successfully. But big countries are so much bigger (see Chapter VI in the Handbook) that a source of comparative advantage for them is sometimes that the global market is so big that a bunch of it gets filled by the big players even if they don't have comparative advantage. This is why a place like the U.S. has someone somewhere making pretty much everything.

But I think SE was asking about textbook examples, so let's work that out.

Consider the two region two good case: Iowa and Nebraska producing corn and wheat. So you need 2 pair of numbers (one for each good) to work out a comparative advantage problem. There are 4 possibilities for those numbers.

The numbers in both pairs are ties.

	Corn	Wheat
Iowa	2	3
Nebraska	2	3

In the above case, no one has a comparative advantage, so the example is irrelevant to the question.

The second case is that number in one pair is tied. But in the other pair, one of the regions, say Iowa, has a higher number: so Iowa has an absolute advantage at wheat.

	Corn	Wheat
Iowa	2	4
Nebraska	2	3

If you work out this table, then Nebraska has the comparative advantage in corn (and Iowa in wheat). Now I'm not sure what to write. The question says "Unless one country has an absolute advantage ...", but Iowa does, so I'm not sure if that means the question  doesn't apply here. But the second part is right: the comparative advantage does go to the one with the bigger number.

The third case is that neither pair is tied, but the higher value in one pair is for Iowa, and the higher value is for Nebraska in the other pair.

	Corn	Wheat
Iowa	2	4
Nebraska	3	3

You can actually prove that this third table is a special case of the second one, and the pattern of trade is the same. I have the same problem with the question though, since now we have two absolute advantages.

The last case is that neither pair is tied, and one region, say Iowa, always has a bigger number, and, the proportions in the rows are not the same.

	Corn	Wheat
Iowa	3	4
Nebraska	2	3

In this one, there's two possibilities. With the numbers above, Iowa has the comparative advantage in corn. But if we slowly increase that 4, eventually the pattern will shift so that Iowa has the comparative advantage in wheat (and the same sort of thing could happen if we changed the other numbers too). So in this one, the comparative advantage does not always go to the bigger number.

I think the lesson here is just to always work out comparative advantage because it's just not that easy to eyeball the numbers and get it right.

Financial Contagion

Macroeconomically, we're worried about Russia because they may not be able to pay their bills. But they do have the money when things get straightened out.

But Russia's actions put pressure on other countries, and those countries may not have a big money cushion.

When financial problems hop from one region to another it's called contagion.

This week it appears as though the first sovereign default in several years may be Sri Lanka. Tuesday, they announced they were going to stop making payments on debts, in hopes something will come through for them during their 30 day grace period.

That something might be an IMF loan. The problem is the IMF usually wants debtors to be making payments before giving them new loans.

***

Sri Lanka banned the use of fertilizer last year. Farm yields are down and prices are up.

On the surface, they said this was so the country could go organic (see here and here).

Unwritten in that is that most fertilizer is imported into Sri Lanka. And fertilizer production is heavily dependent on crude oil prices. Might not have been able to afford that because COVID-19 killed their tourism industry.

This Is Astounding

In macroeconomics, Larry Summers is huge. Professor at Harvard (youngest tenured economics professor ... ever). On everyone's medium list for a future Nobel Prize. Entered MIT at age 16. Won the John Bates Clark Medal (given to the best economist under the age of 40) — widely seen as a Nobel predictor — in 1993 (the two people who won the medal before and after Summers already have won their Nobel prizes).

In Democratic politics, Larry Summers is huge. Economic advisor to the 1988 Dukakis campaign. Chief Economist at the World Bank (not political, but generally liberally oriented). Undersecretary for International Affairs, and later Secretary of the Treasury during the Clinton administration. Served on Obama's transition team. Then directed Obama's National Economic Council (an alternative to the Council of Economic Advisors, doing more policy and less research). Initially an advisor to the Biden campaign, but he got pushed out.

In economics, Larry Summers is royalty. His mother and father were both economics professors at Penn (she's in the Wharton School, he was in the economics department). Mother, Anita, was recruited as one of the initial faculty in the first public policy schools in a business school, where she taught urban economics specializing in census data. Father, Robert, did seminal work in applying purchasing power parity to the GDP of countries around the world, and helped created the original Penn World Tables on which a lot of cross-sectional macroeconomics are based. Oh ... and her brother, Ken Arrow, won a Nobel Prize in 1972, and his brother, Paul Samuelson, won a Nobel Prize in 1970 (and both of them won the John Bates Clark Medal earlier, in 1947 and 1957).

Oh ... and being an economist on the White House's Council of Economic Advisors is not very political. But maybe a little embarrassing for a Democrat if you worked on Reagan's, as Summers did. 

Oh ... and President of Harvard for a few years (not a Republican place).

Oh ... and important enough to be portrayed in The Social Network.

***

I have personal reasons to dislike Larry Summers (did not play nice academically with friends of mine).

Professionally, I've read a ton of his papers and I like them, but I've never read one that super-impressed me. That's OK.

Summers has come up many times on this blog, since its inception: here's a search page linking to the 20 times I've written something related to him.

***

In short, if you're an economics major, and Larry Summers says something ... listen. If he writes something ... try and find time to read it. That's hard: it seems like he writes more paragraphs than most professors write words.

***

Summers is on the outs with the Biden White House. He was pushed out by progressives before the election.

***

Soooooo ... Ezra Klein, a progressive economics guest columnist for the New York Times (and co-founder of Vox) interviewed Summers on what's gone wrong with inflation and current policies. You can read the transcript or listen to the podcast. They're both easy to find online, and ungated.

I've posted a highlighted and commented version to the class's folder on Google Drive. DO NOT just read the highlights and comments ... that's the regurgitated version for my principles students. The big kids get to read the whole thing.

This piece is astounding. He all but calls President Biden and/or Senator Warren idiots (amongst others). And he suggests that White House advisors are so off base and have lost so much credibility that they should get less attention. 

He says this because his read on the data is that inflation is bad, continuing to get worse, intentionally caused by political operatives who were dismissive of the economic concerns voiced by economists, and who still don't get it. 

He also notes, with some evident disgust, that poor Democratic policies in the 1960's and 1970's led directly to Margaret Thatcher and Ronald Reagan. He sounds worried about the current situation.

***

There's an acronym, RINO, short for Republicans In Name Only. It applies to Republican politicians who tend to vote for Democratic proposals more often.For example, Senator Romney is often called a RINO.

There's needs to be an alternative one — DINO — for Democratic In Name Only. But for very different reasons.

I heard a joke about a month ago that the Republican Party is being held political hostage by its crazy majority, while the Democratic Party is being held political hostage by its crazy minority.

So to me, a DINO is one of the minority of contemporary progressives who are in frequent conflict with the way the majority of Democrats thought as recently as a few years ago.

Economically, the Biden White House is all DINO's. It is hard to emphasize sufficiently that being in an intellectual war with Larry Summers is repudiating everything Democrats have stood for the last 2 generations. What we are seeing is not Democrats vs. Republicans, it's DINO's vs. {Democrats & Republicans}.

And the DINO's are proud of this. They view the 2020's as a big referendum on their progressive policies. If the economy turns out great, they win the argument. They've been very clear about this (see here, here, here, here, and here). I'd say it's still before halftime, but they're already behind.

Oil Pipelines and Refineries

Earlier in the semester I posted about crude oil, and how it has to go through a refinery, and is often used quite close to the source.

Pipelines for water, oil, and natural gas are an essential part of the broader class of infrastructure.

Visual Capitalist has posted a map of North American pipelines and refineries. This is a screen capture:

 

The graphic on their site is interactive, and worth a visit. Lots more there.

Our local pipeline is not on here. It is big enough to be included, so perhaps the underlying data is old, or difficult to acquire in complete form. Also not on here is the Enbridge 5 pipeline from Michigan to Ontario, where needed upgrades are being blocked for political reasons (basically, a politician is against oil — which is OK, that's why we have elections — so they're blocking upgrades to something that's working fine ... which is kind of jerky). Also not shown is the partially built, but now cancelled, Keystone XL pipeline, which would have been just another one in the big complex going across the plains from Alberta to Texas.

So, a few macroeconomically important things here. 

First, pipeline work best where it's flat-ish: they're mostly across the middle of the country. This makes it easy for them to ship stuff all over, which means less price volatility in these regions. It does not usually mean lower prices: regional differences with that usually have a lot more to do with excise tax differences.

Second, the east and west coasts are isolated by mountains. Most of their oil is shipped in (on the right coast), or drilled in state (the left coast). This makes them subject to more volatile price fluctuations: they are oil islands.

Third, the biggest refineries are along the Gulf coast. This is only partially because Texas has a lot of oil. It's also because, historically, Venezuela was a huge input source for those refineries. Later on Mexico came online too. The economic suicide of Venezuela over the last 25 years has greatly reduced the workload at those refineries.

***

A personal note here: if you know what to look for, you'll see a lot less oil trucks, oil train cars, and big storage tanks in the central part of the country. They're much more common east of the Mississippi and Ohio Rivers, and west of the Rockies. This is because the alternative to pipelines is not less oil, it's more truck and trains and tanks (and accidents). Most of you are economics majors, and you should always condition yourself to think about tradeoffs: lots of weak economic thinking by non-economists is not thinking enough about tradeoffs and alternatives.

European Natural Gas Infographic

How dependent is Europe on natural gas from Russia? This may help answer the question:

 

First, a couple of details. 

Natural gas can be produced, and is, in many more places than this (note how big the "Other Europe" band at the lower left). But there are economies of scale in its production (like crude oil, it's a high volume low margin business). 

This isn't showing production or consumption, just exports and imports. Some of the countries may be satisfying most of their gas consumption with their own production (recall the lecture in the old classroom where I noted that we draw invisible lines on maps call borders, and then treat trade across them as different or more important or more worthy of our attention).

Also, natural gas can be liquefied and shipped by land and sea, but this is still fairly rare. Almost all of it goes by pipeline. And that's what this graphic shows.

Then there's a physical feature to keep in mind. Gases are unruly, in a way that liquids and solids aren't. To work, a gas pipeline has to be under pressure, and to be under pressure it has to be full all of the time, and constantly resupplied. You can turn them on and off, but there isn't much leeway in the middle. So once you build the things, you have to use them at full capacity most of the time.

So in the graphic it shows that the real dependency on Russian gas is in Germany, while Italy and Turkey also rely on it heavily. What's not shown in detail is what's in those "Other Europe" receivers. Since most of the countries shown specifically are in western Europe, I'd imagine that those are eastern European countries along the pipelines. The big ones macroeconomically are Poland ... and Ukraine.

Russia is Running Out of Room for Oil

A few weeks back I spent most of a class day talking about a long post about how the oil industry works.

One of the things I noted in passing is that there's never that much oil in storage. Some, but there's just not infinite room for it. Also, a good fraction of the oil that is "stored" is not actually in tanks, but in the pipelines from the tanks and wells to the refineries (basically, the pipelines can hold a lot). There's actually an aphorism for this: "store it in the ground" by not bringing it to the surface just yet.

A seemingly unrelated issue that I also mentioned at some point regarding Russia is that many oil wells can't be turned off readily. The oil is coming up, and it has to be sent somewhere. In many cases, to stop a well from production pretty much means to ruin it for good. It's not straightforward, and there are safety issues. In the U.S., when well are shut down it's required by law that they be sealed by pouring concrete down them so they can't be opened up again. Safer to drill a new one from scratch off to the side, than to re-open them.

Anyway, if you put those two together, a slow moving problem that has been approaching Russia is that if they can't sell their oil, and their storage fills up, they'll have to destroy wells.

That day may be here. Transneft is a Russian company that operates the largest pipeline network in the world. This map is in Russian, but is all I could find:

Transneft has notified oil drillers that they are out of room, and are limiting intake. Further, they want proof that there is a buyer who will take any oil they agree to store.

The article does talk optimistically about future upturns in Russia's oil sales. I'm not clear on this, but my guess is that what is going on is that the oil firms are still booking sales for April and May that may ultimately be cancelled.

Cryptocurrency Seizures Not That Easy (Not Required)

I'm not sure how this number will turn out for Russia (seeing that sanctions on official accounts for conventional money appear to be only about 60% effective).

But the evidence is that Canada was only able to seize/block about 30% of Bitcoin donated to the protesting Canadian truckers. Not sure about other cryptocurrencies either.

The main reason appears to be the choice of "wallet" used. Those who kept passwords on their own still have their money. Those who lost it used services where passwords were maintained in a centralized database: basically, is the key needed to make your password work stored on your own device or on a server somewhere.

The link is here, but it is not open, so it's not required. You do get a free look if it's your first time on the site.

Yield Curve Inversion as a Signal of Recession

Using the yield curve as a tool to forecast recessions is ... popular again ... but still probably for no good reason.

First off, recessions aren't really predictable at all. This is what makes them a problem. 

FWIW: forecasting recessions is arguably the single most studied problem in human history. If it had an easy answer, don't you think we'd just tell you?

Second, the yield curve is kind of mysterious. Because it isn't a number. It's a curve. How do you summarize it quickly? I know what it means to say that a number X causes a number Y, or that when X goes up by 1%, Y goes up by 3%. I don't know what it means to say a curve (or the shape of a curve) causes a number. Huh?

***

A lot of people don't even know what a yield curve is, in the sense of how you'd put one together if you were doing it by hand. 

Here goes. First, you'd need to have securities from which you can measure interest rates. Second, you need those securities to have different maturities. Third, they need to be securities on the same sort of thing, because rates can differ across different securities depending on risk, preferences, senior vs. junior status, bankruptcy features, covenants, and so on.

When you think about this, you can't really form a yield curve from say, car loans. Yes, they do have different maturities. But they also have rates that depend on buyer features (like income) and seller features (like how badly they want to get the car off the lot).

Ditto for mortgages. Ditto for corporate bonds, unless you found a corporation that issued debt at a lot of different maturities, and was representative of the whole country.

You're really just looking at government bonds then. So if you were to put together one for the U.S., you'd need to get rates on all the bonds of all maturities. At least this route is possible.

Then you plot, for a point in time, all those rates on the vertical axis, against their maturity on the horizontal axis. If you do you usually get something that's upward sloping.

Inversion is when it's downward sloping.And people on the internet usually start squawking about inversion when any part of the yield curve is downward sloping, even if overall the whole thing seems to be generally upward sloping.

***

A better way to summarize this information is with a gap, usually between the rate on a long maturity bond and a short maturity bond. Usually the latter is lower. An inversion would be when it's higher.

You can actually get this for free from FRED using the keywords fred, yield, and curve in Google. It will be listed as something like: 10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity.

BTW: you can "get" this because it's a number. How would you "get" a curve to download?

If you look, sure enough, it "predicts" recessions.

But what sort of prediction is it? First off, it screams recession over on the left, but nowhere else. The early 80's were bad, but comparable to 2007-9 where it didn't scream recession. Second, the time before a recession is not the same, and it's not that close either. Third, it forecast the 2020 recession, which everyone is pretty sure that was about a pandemic and lockdown. So are we to believe it forecast those too?

It's better to view the gap as reflecting Fed policy. The Fed has much more control over short rates than long rates. And the Fed tends to start "tapping the brakes"  by raising rates late in an expansion. So, if they can't budge the long rate, and they start raising the short rates, the gap will go towards zero ... late in an expansion.

That explanation is a good one. The thing is ... the yield curve doesn't add anything on top of that. So what's the point?

Cynically, I think the point is that it's one more piece of data that doomsayers can crow about. It's up to you to decide if it's one more valuable piece of data.

Those Tricky Russians

Russia is demanding that western Europeans pay for the oil they want in rubles.

Macroeconomically, Russia isn't that big. Depending on how you measure, it's roughly 5% of the world economy. 

Most international trade is conducted in dollars, euros, yen, and pounds. Some is also done in yuan, but it's a smaller proportion than China's share of trade. Little is done in rubles because the only place you can spend them is in Russia.

So, Russia needs a lot of dollars, euros, yen, pounds, and yuan. Few other countries need rubles, and therefore they don't have FX accounts filled with them.

My guess is that the backend of the story is that Russia will make compromises for buyers who are short of rubles. You know ... like we'll do the exchange for you ... as long as you bring dollars, euros, yen, and pounds in briefcases of unmarked currency ... that they can keep in embassies, safe deposit boxes, and numbered bank accounts around the world.

New On Bloomberg Today

Severstal, the Russian steelmaker is unofficially in default. Officially being in default does require the firms who are owed money to file for that. They have not done so, because they'd rather have their money sent on to them. Severstal's bank has told them that they need to get a permission letter from the U.S. Treasury to get their payment to move forward. 

Severastal is not under sanctions, and neither is the particular oligarch who is its largest shareholder. So no one is quite sure what the hold up is.

Evraz, another Russian steelmaker, did have their payment go through.

But Evraz's majority shareholder is an oligarch who's been sanctioned (he also was the owner of the Chelsea football club in London). No one understand why this one went through.

***

Oil is back up. Brent is at $119/barrel, WTI is at $113/barrel.

***

Financial contagion is starting to be a bigger worry. Russia has problems with its dollar-denominated debt. The dollar-denominated debt of all  the countries and firms in those countries that are in bad shape is over $500B.

A way to judge what "in bad shape" means is to use an interest rate cutoff. That $500B comes from counting only those countries whose interest rates are more than 10% higher than that of the U.S.

The big one is Belarus, but Ukraine is also near the top of the list. Lebanon (a failed state for other reasons) is another. The rest of the list is Sri Lanka, Zambia (which defaulted in 2020), El Salvador, Tunisia, Ethiopia, Suriname, Tajikistan, Argentina (which defaulted twice this century), Ghana, and Pakistan.

What they're worried about with contagion is that investors start to worry about getting payments from these countries, so they start selling bonds by dropping their asking price, and that pushes up interest rates. So the rate isn't really important; rather it's the measure of problems. 

The problem with international financial contagion is that there really doesn't have to be a well-connected cause for it to happen. It's like a bank run. Except on countries, and their big tax-paying employers.

***

Egypt has applied to the IMF for a special loan. This suggests they are having trouble too. Reports are this is from an expected huge drop in tourism: it's a short and straight shot south from Ukraine or Russia, and apparently 40% of tourists in Egypt are from those 2 countries. Who knew??

Fitch Backs Out of Russian Private and Public Ratings

Amongst the ratings agencies, Fitch is the one with the biggest coverage of Russian issues. They've announced they're stopping rating them completely.

The simplest interpretation of this is that most investment finance is barred from buying things that are unrated. So Russia (the government) and Russians (firms and people) won't be able to borrow money as easily. 

I wonder whether or not that will make a difference to their economy. It's not like anyone is lining up to loan them money now.

But there's a bigger and subtler issue.

When an institution wants to borrow they sell a bond to a buyer. The payment for the bond is the loan. But that's just the first seller and first buyer. The bond is a security and can be resold. So the first buyer becomes the second seller of that security, and goes and finds a second buyer. All of those sales from the second on are called seasoned. 

On the surface, Fitch's move will help shut down initial offerings, but at the deeper level, it will also shut down the sale of seasoned Russian securities too, since most institutions can't buy unrated bonds.

The macroeconomic consequence of that is that institutions make themselves more liquid by selling bonds they own (which, by definition, are all seasoned). So Fitch's move blocks conversion to liquidity of part of the portfolio of many institutional investors. So where will they get liquidity? By selling more of the bonds of other countries. To sell them they will need to drop their price, pushing up interest rates for (new borrowing) for those countries. In essence, it will be an external creation of more contractionary monetary policy. That will be met with an intentional and internal expansionary policy in those countries ... encouraging inflation there. 

Great. Juuuust great.

Private Defaults in Russia?

The Russian government may have been able to make its debt payment in dollars last week, but it's not clear that some Russian private firms can make their payments this week. They may default on Wednesday.

A Russian steelmaker, Severstal, claims to have forwarded a $12M payment on its bonds. But again, the bankers are not sure they can accept the money if it is under sanctions.

Nickel Shenanigans?

The Wall Street Journal (in an op-ed piece) accused parties unknown of manipulating the nickel market to help reduce the outstanding margin call (from $15B to $8B) of the Chinese tycoon known as "Big Shot".

In particular, as it became clear that Big Shot was in trouble, traders took advantage by buying nickel to drive up the price, increasing his margin calls. The accusation is that the Hong Kong based owners of the exchange retroactively cancelled profitable trades.

I'm not sure what to make of all of this macroeconomically, but the $8B he did come up with, apparently with the backing of the government in Beijing, is a large some for a financial system to come up with quickly. Keep in mind that this is 70 times as big as the payment that Russia almost defaulted on last week.

And ... not a good thing for China when China seems to have a whole lot of other macro-financial problems.

A G20 Move?

The G20 is covered in the infamous Chapter VI of the Handbook.

In short, it's an international organization of some of the largest economies BUT they're mostly chosen for political reasons, which is kind of weird.

Anyway, the leaders of the G20 have summits where they try to coordinate macroeconomic and regulatory policies internationally (which is a good thing). For example, the Biden administrations trial balloon of a uniform tax on corporate profits across countries of 15% is a G20 idea.

Today's news is that Poland has asked that Russia be expelled from the G20,† and the U.S. views that suggestion positively. This would be another way to sanction Russia.

Note that there's a smaller group of bigger economies called the G7. It used to be G8, but they booted out Russia after they invaded Ukraine in 2014, so there is a precedent for this.

† This is a little strange too. The composition of the G20 includes 4 big European economies, but it also includes the European Union of which 3 of them are members. The idea is that the EU votes on behalf of the other 24 countries (including Poland). But it might also imply that Germany, France and Italy get 1+ votes in the meetings? Maybe so.

Don't Forget About China

I started the semester with financial problems in China, that could have macroeconomic consequences since China is one of the big two economies in the world. 

And while no one is paying attention, there's still all sorts of juicy stuff coming out, none of it good.

• COVID-19 on the rise, and new lockdowns enacted.
• Their stock market is off 60% since last year. Macroeconomically, stock markets are overrated ... but 60% is an awful lot for things not to be generally lousy.
  
• Their bond markets are also doing badly (and it's unusual to get both markets down at the same time). Higher rates and lower prices go together, and that either means people aren't buying (demand shifted left) or there's a lot more borrowing (the supply of bonds shifted to the right). Not so ...
  
• Property developers continue to go bankrupt, because ...
  
• Households aren't borrowing to buy new apartments.
• China practices floating exchange rates. Bad news with this policy shows up as the acceptable bands for exchange rates widen (and they have). Usually this means that a central bank is having trouble keeping the rates within narrower bands as people bail out of the currency.
• International investors adjust their liquidity by buying and selling government bonds. Developing markets like China's typically offer higher rates, which investors also like. Closing of markets in Russian debt have encouraged some investors to look towards other big markets where they can still sell out. Of course, the U.S. market is bigger still, but we're the market people buy into when they're worried; China is a market the sell out of.

Update: After class, news came out that creditors seized $2B in bank accounts from Evergrande. Suspicions are that the money was taken by a Chinese bank over unserviced loans. This is a weird situation. China doesn't usually let things like this happen. What does it mean for their macroeconomy if Beijing can't control things?

If You Like Cars (Not Required)

Lamborghini has decided to restart production of its discontinued Aventador line after the last 15 of them burned and sank to the bottom of the Atlantic.

Presumably, those had been pre-purchased (most expensive, custom, vehicles are), and at about $500K a piece, perhaps it makes sense to restart production.

***

If you pay attention around southern Utah, you'll see one of these every year or so. Many or them are owned by rental places in Las Vegas that target high rollers and last night's big winners.

The Heat Is Still On Under the Inflation Kettle

Inflation continues to rise. Here's the story with consumer prices, and producer prices (which lead consumer prices by several months) are worse.

Outside of macroeconomics class, your response to friend's and family about this should be ... "Duh". This is what inflation does. 

It is like putting a pot of water to boil on the stove, and when it start to rise up to overflow the pot you need to do something about the cause. Hopefully you have several causes in mind, and an awareness that this didn't happen overnight. Or not.

We're not really doing much at all about those, but do keep in mind that it's early, this won't be easy, and we live in interesting times. Continue to bet on it getting worse before it gets better.

***

It is hard to explain to students who've never lived through an inflationary period what it's like. Here's someone's reminisces of the 1970's.

Many of you have connections to California, and there are reasons that gas is always more expensive there. Some of those have been around for a long time; more recent environmental policies have made it worse.

COVID-19 and Lockdowns in Hong Kong and China

Oh yeah ... COVID-19 didn't go away. We just gave up. Maybe it's even on the way back in the U.S. Won't that be fun.

Hong Kong is currently experiencing the highest death rate of any region ... ever. It's approximately 3 times the rate for the U.S. at our worst (in January '21, before they even started coming up with Greek letter names, when that was known as the third wave). 

This is macroeconomically important because Hong Kong ... by itself (!!!) ... is in the 80's for its percentile of countries around the world as ranked by GDP — comparable to Nigeria, Denmark, Israel, Colombia, or South Africa.

***

China used the world's inattention during the first 9 months of COVID-19 to seriously take over the political and social system in Hong Kong.

So this is happening in spite of China's zero tolerance policy towards infections.

Instead, the problem appears to be that China has its own vaccine, but hasn't been that great at vaccinating a big proportion of their population. Macroeconomically, self-sufficiency is not a great thing.

This breakout has spread to Shenzen (badly), and Shanghai (somewhat). These are the 3rd biggest, and biggest cities in China. Shenzen is locked down.

***

I am not a great believer in the position of the Biden White House that current inflation is due to supply chain problems which are due to COVID-19 issues. It's a factor, I just don't think it's the big one.

Shutting down Shenzen is going to make this a much bigger factor for the U.S. through summer.

Crude Oil Is Going Back Up

Brent (the benchmark for Europe) is back up to about $115/barrel. WTI (the benchmark for our hemisphere) is around the same price.

Hard to say where this is heading. But for macro purposes, the big deal is that it isn't $80/barrel like a few months ago, or $40/barrel like a year ago.

Russia Repercussions

After worrying about ruble depreciation, price increases for CDS's, sanctions, oil prices, and defaults ... the list starts to expand to other countries. 

The problem is financial contagion. It's not happening yet, but it does happen, so ... now the worries are global liquidity, remittances, Russian domestic borrowing, and depth of involvement in Russian markets.

Bonds are straightforward to price, so they tend to be sold readily when investors need more liquidity. Russian bonds used to be fairly high on the list of what's available in quantity from developing countries where interest rates are often higher. So if people can't sell their Russian bonds as needed, they'll sell something else. We're beginning to see investors selling off more than the usual amounts of bonds (driving down their prices, and driving up their rates) in other large, emerging markets, including China, Indonesia, Mexico, and Thailand. Not a big worry yet. Higher CDS prices also indicate nervousness amongst investors in El Salvador, Ghana, and Tunisia.

Remittances are the shares of incomes that immigrants (permanent or temporary, legal or illegal) make in a higher-paying host country, which get sent home to families where the money goes further. People in rich, developed, countries tend not to know this, but these are often a major component of the GDP of small, poor, countries. The problem here is that Russia is one of those host countries. So sanctions are going to start hitting countries like Tajikistan, Uzbekistan, Armenia, and Georgia in fairly short order. That risk gets amplified if those countries in turn have debts requiring interest payments in euros or dollars.

The bonds I've discussed so far are international borrowing. But, like other countries, the government of Russia also sells bonds inside the country (nicknamed OFZ's). These are often used for managing cash flows and liquidity. Here's the thing: if they're bonds, even if you sell them locally, anyone internationally can buy them from a reseller. Russia has already sort'of defaulted on these. Interest payments on them that were due this month were paid on time to Russian holders. But no payments went out to foreign holders. Everyone is wondering why these have not been declared to be in default yet. But the expectation is that at some point they will be. Russia's quasi-default in 1998, which in part led to Putin succeeding Yeltsin, involved Russia honoring its international bond payments, but defaulting on its domestic ones (which probably made Russians leery of financing their government, which then went more international over the last 15 years).

Lastly, there's the general problem of outstanding investments in Russia. The sovereign debt (the part borrowed by the government) of Russia is about $60B, of which a third require interest payments in euros or dollars (we just dealt with $4.5B of that yesterday). But private Russian firms have borrowed about $250B from western investors, and those firms often have little latitude to make their interest payments (some are already defaulting, but they're all small). The biggest exposure is in France, Italy, and Austria. Those are the place that will get wobbly with sanctions first.

May You Live In Interesting Times 2 (Not Required)

Ummm ... is it weird if another ship carrying cars sank? 'cause I don't remember this happening very often before ... or probably ever before.

Anyway, the ship went down in bad weather in the Persian Gulf. No news on what type of cars were on this ship. No one knows what happened. Almost all of the crew were rescued from the water (a sign that the sinking was fast).

The Rest of the Story (for This Week) On Russia's Bonds

The news hit the internet at 11:17. We were in class, but it was there when we got out and checked the Bloomberg terminal.

Russia did pay the dollar-denominated interest on those two sets of bonds, on time.

This is a strong signal that default scares the c**p out of Putin and other decision-makers.†

***

So, there are sanctions on Russia's accounts in the west. But they aren't complete.

On Monday, Russia got a communication, presumably without using SWIFT, to its correspondent bank, J.P. Morgan. This connected them to an account somewhere with dollars in it that was not under sanction. Russia has about $100B in FX in China, but it's not clear if that's held in dollars or not.

J.P. Morgan did not know if this was OK, so they contacted the U.S. Department of the Treasury. There, the Office of Foreign Asset Control (I'd never heard of that either) made the decision that 1) they can do whatever they want with non-sanctioned accounts, and 2) it's OK for anyone to accept money from Russia (it's not clear if that is only from non-sanctioned accounts or all accounts). Both of those are OK until some time in May.

When that came through, J.P. Morgan forwarded the money to Citibank, which handles disbursals for those bonds. Investors started getting there money by this afternoon.

This all sounds a little hokey. But, the idea of sanctions is to get the money out of Russian hands. Allowing the payment got non-sanctioned money out of Russian hands, and  kept international investors happy, so it's a win-win.

***

So, not only didn't Russia default (this time), they paid in dollars instead of rubles.

I had missed this, but apparently the CDDC ruled on Friday that paying the interest on those bonds in rubles — because it was part of the contract — was OK.

But Russia didn't take advantage of that. Why?

My guess is that even though it would have been legal, the Russians were told that if they did this it would not be viewed as a good faith payment, and that institutional investors would hold that against them (by charging them a much higher rate) in the future.

***

Earlier this week you could've bought those Russian bonds for about 20% of their maturity value. Now that's up to 40%.

The price of CDS's on Russian 5 year bonds has dropped down to about $1,700.

Next up are payments that have to be made in euros on the next two Mondays.

† Why are bond defaults such a bad thing? Because no one will loan you new money until you settle the old loans. The Washington Post reports in "Will Russian Bonds Default? There's Debate About That" that some bonds from Czarist Russia that were repudiated by Lenin after the Russian Revolution were settled in 1986. And a letter to the editor of the Wall Street Journal notes that before France would allow Russia to sell bonds there in 2001, they had to make payments on bonds people had been holding onto since the 1890's, which had also been repudiated by Lenin. I hadn't heard of the first case, but I do recall being amused at the second one when it was in the news.

Russia Surprises Bond Markets

This is still up in the air ... but it seems like Russia made its interest payment in dollars yesterday like it was supposed to.

But no one is being clear on this.

The Russians say they paid.

Holders of those bonds are saying they didn't get any interest ... yet.

And the banks that would make all this happen ... haven't said a word.

My guess is that there are some legalities involved in whether the dollars that were used were actually accessible, either by Russia, or by the banks clearing the loans. 

While the U.S. and others have blocked a lot of Russia's financial capabilities, the U.S. Treasury issued a statement saying that if money from Russia actually makes it as far as you, you're allowed to accept it. But this begs the question of who is not accepting funds that are available to them, because somehow no one is saying there's a default either. If there was, a 30 day grace period would need to be publicly declared. But for now, the Russians are saying that they have not received confirmation that their payment has been accepted or declined.

***

There's an aphorism that you should get used to. It says something along the lines of "May you live in interesting times.". It's not intended to be a compliment.

Federal Reserve Policy Shift

The FOMC shifted into a contractionary monetary policy at this week's meeting. Their target interest rate was raised by 0.25% (or 25 basis points) to a range of 0.25-0.50%.

This move was expected. However, the repercussions of the war in Ukraine are broadly expected to have a contractionary effect too. I think this made some members a little leery of taking this step (the vote was 8-1, with the no vote wanting a bigger 0.5% increase). (In a post yesterday for my principles classes, I put the odds on a 0.50% increase at 20%, 50% on the 0.25% increase they chose, and 30% on no change at all).

Even so, inflation is a problem, and the Fed is the institution primarily responsible for addressing this. The underlying idea is that inflation results from more willingness to spend than ability to produce. Raising interest rates will discourage some spending.

I describe monetary policy in the U.S. as a sequence of baby steps. In this chart you can see extended periods where rates are raised or lowered several times in a row.

This is intentional, so we can probably expect rates to be raised many times over the next couple of years.

The FOMC releases an extensive report after its meetings. One of the items in there is the forecasts of where the individual members think interest rates will be in the future (at year's end):

There is a little bit of a trick here. The FOMC is composed of the 7 Governors from the Board of Governors in D.C., and the Presidents of the 12 Federal Reserve Banks around the country. That's 19 people in the meeting. But not all of them vote:

• 7 Governors always vote
• 1 President, of the Federal Reserve Bank of New York, always votes
• 4 out of the other 11 Bank Presidents vote on a rotating basis (for a year, roughly every third year)

The thing is, sometimes there are vacancies, particularly amongst the Governors (there are vacancies amongst Bank Presidents, but they have day-to-day local duties, so those jobs aren't open for long). Currently there are 3 vacancies amongst Governors. So, 16 people were in the meeting (and there are 16 dots in each group on the graph), while 9 people voted. 

FOMC meetings are scheduled in advance. There are 6 more this year. The dot that's lowest on the left, the member that expects the least rate increases) is forecasting 4 more increases of this size for this year. The median forecast is 6 for 6. 

On the top chart, some of the steps are wider, and that indicates ac couple of meetings in a row in which they voted for no change. 

Of course, they could always go for a bigger increase at some meeting, but the top chart shows they haven't done this any time in the past 25 years. They have brought their target down in big steps a few times.

Also, the FOMC can have emergency meetings between scheduled ones. For example, two years ago, just before the lockdowns, they dropped interest rates twice between meetings, in anticipation of the economy going downhill rapidly.

***

There are fairly serious arguments made by academic macroeconomists that the FOMC was not aggressive enough at raising interest rates after the 2001 recession, and that this encouraged the formation of an asset price bubble that contributed to the financial crisis of 2006-9. The argument here is that interest rates that were too low encouraged people to buy assets they could not afford later on.

The same argument was made 4-10 years ago about the Fed's behavior then. However, we did not end up with a price bubble or financial crisis.

Yesterday, in a strongly worded opinion piece, the Wall Street Journal emphasized the position that the Fed is too timid about fighting demand pressures.

***

You may be wondering why I emphasize this topic less than the popular media does. This is because the time series portion of this course teaches us that it's just not as big a deal as it's made out to be. Look for that message when we start covering in class what's called Case 5 in my text.