Strong Views Lightly Held

A friend wondered if there were any lessons from Japan’s experience of population decline.

The “lesson” from Japan is that no-one has a playbook for managing decline.  Global population has been going up for so long.  So everyone has an opinion on how to manage growth.  But how do you manage….

• Shutting down whole towns?
• writing off or maintaining under-utilized or surplus infrastructure?
• the debt/asset valuation consequences of the above.  (rhyming with “the thing that will make global warming real to most indifferent ordinary people will be when banks will no longer write mortgages and no-one will insure coastal-region homes near (rising) sea-levels…”)

Decay is a very different process than growth.  Per the Cleveland example below, how do you nudge/force people out of their home into smaller clusters so you can start shutting down un-needed fire stations?  When do you stop maintaining the road to reach some dying town? Un-building is very different from building.
One lesson we do have from Japan:  decline will happen faster in some places than others.  The least desirable places look like the Zombie apocalypse.  The top 15% living in the “attractive” places don’t notice a thing – at least until “the deplorables” get your attention by, for example, voting for Trump… 🙂

We will see the same unbalanced dynamic across borders.  Per the Lancet paper, most poor countries are shrinking too.  So the “immigration solution” is just rich countries draining the poorer countries even faster than their population declines would naturally.

Note also that Africa is the only region that will be producing net new people. So “encouraging immigration” really comes down to “encouraging African immigration.” Think about that for a bit. Maybe envision Donald Trump opining on that particular subject…?

Another lesson from Japan.  The immigration solution will run smack into deeply embedded nativist-to-straight-out-racist cultural strains in the US, Europe, AND Asia. The good news? A lot of people will eventually learn to cope with having an African-trained doctor if the alternative is no doctor at all. The bad news? That process will involve a lot of conflict and magical thinking.

More to the point, the world hasn’t even started hollowing out. Like climate change, that will happen gradually and then suddenly.  We live in interesting times.

I was reminded of a post I wrote last year by the news that China’s birth rate dropped by 45%.  As I wrote then:  “A study in the Lancet forecasts total world population will decline A LOT over the next 70 years.  China’s population, for example. could drop by half.  700 million fewer people than their peak population year in 2024.  As the study somewhat blandly puts it…”

Our forecasts for a shrinking global population have positive implications for the environment, climate change, and food production, but possible negative implications for labour forces, economic growth, and social support systems in parts of the world with the greatest fertility declines.”

“Possible Negative Implications?”   Wouldn’t “multi-decade deflationary shock?” be a more appropriate descriptor?

The simplest example is housing.  Fewer people need fewer houses.  What do we do with the left-over homes no-one will ever live in again?  What do we do with the cities and towns where they will be concentrated?

I don’t have any good answers to that and many other questions.  I do worry that no-one else does either.

What we do know is that this trend is deeply deflationary.  Most of those houses now carry some notional value often backed up by very real debt.  But if no-one is there to buy the house when the last owner dies, the asset value (and the associated debt value) are gone.  Buried in his/her grave.

You can make shorter-term arguments that a shortage of job-age workers will drive inflation.  This makes sense,  But the next 80 years will see fewer people occupying fewer house and buying less stuff in a world whose productive capacity and asset based is sized for millions more people who no longer exist.

We live in interesting times.

We are All Japan?  Especially China? World Population DOWN by 2100? China’s Population Cut in Half?

“Barring some sort of birthrate uptick China’s a country of 1.4 billion that very soon is going to have a child population you’d expect in a country of 700 million. Very weird future.”

Births in China have fallen by 45% in 5 years, which is just catastrophic: pic.twitter.com/MFBAb7tilC

— Conor Sen (@conorsen) January 17, 2023

So we all know big chunks of the US Republican Party want to stop giving a dime to Ukraine.  But we really don’t know why?

It is clearly in the US national interest to weaken a dangerous, unpredictable rival (Russia) and warn other possible invaders that the world won’t just stand by (China and Iran).  Moreover, we are basically destroying the Russian military with no loss of American life for a ridiculously tiny amount of money.  Especially when you remember that a lot of that “aid” is sending US hardware that will be replaced by spending US dollars in the US.  You’d expect the same Congress that over-funds the Pentagon every year would like that.

So why are the Republicans so opposed?  I can think of 4 explanations.  None of them are good.

1. Knee Jerk Isolationism:  I can kinda sorta get this, but we are spending peanuts, risking no lives, and avoiding obvious problems (like NATO obligations) down the line.  If you dream of quitting NATO to pull up the drawbridge completely, maybe the isolationist fantasy all hangs together.  But it remains a fantasy.  If we ignore the world, it will still come find us (see “9/11”).
2. Political Calculation:  Owning the Libs trumps everything else…  If it denies a win for Biden, they will vote for America to lose.  You can’t let “them” claim any successes.  The next election counts for more than the country’s best interests.
3. Strongman Crush:  There are a lot of people who not-so-secretly admire Putin and Xi.  It is a model they hope to emulate.  Blithely confident they and their families will ALWAYS be on the side of the strongman.  Any eggs that get broken making that omelette will certainly be someone loser leftie’s children.
4. Just Plain Traitorous:  The Russians have splashed a lot of money around and they have a lot of compromising pictures.  Maybe there is just a lot of smoke and no fire.  But look past the Trump/Putin rumors.  Think about (former Democrat) Tulsi Gabbard’s quixotic, robotic Presidential run that seemed to rest wholly on a platform “lets hand Syria over to the Russians!  This is the most important issue in America today!”  Where did that come from?  Genuine conviction or…?  Is everyone in Putin’s pocket?  No.  But are a few people leading the charge perhaps bent a little?  Maybe…

All of the above doesn’t mean the Democrats are paragons of virtue here.  Tulsi Gabbard used to be a Democrat.  But the Democrats are generally voting to advance what is clearly in the US National interest.  An extraordinarily cheap, bloodless (for us) destruction of a major military threat.  The mystery remains as to why so many Republicans are so loudly against that…

I’d probably guess “all of the above.”  But none of the above are smart or patriotic choices.

People keep bringing up the “what if Putin uses a tactical nuke?” as if that would change the situation in Ukraine.  It wouldn’t shift the military balance.  It would drastically shift the political entirely against Putin’s own interests.  Threatening to use a nuke is one thing.  Actually using one would be a total disaster for Putin and for Russia.

Militarily, a tactical nuke doesn’t do anything that you can’t do with conventional weapons.  Hence the term “tactical.”  It could be useful IF there was some major supply or military choke point that Russia could hit (like the Kerch bridge to Crimea, but that is Russia’s choke point not Ukraine’s).  But there isn’t any such choke point.  So a big boom would go off and destroy a lot of local assets and people.  But where do you go from there?  Putin no longer has enough trained troops to even exploit the gap in the lines.

So a nuke is largely a “branding” exercise.  Its power lies in the name and nature of the weapon, not the force of the blast.  Using it, Putin would irrevocably cross a line to become most-hated-guy-on-earth.

What do you think happens in the hours days that would follow a Russian nuclear strike.  Will the whole world bow down in humble submission to acknowledge Putin’s steely determination?  No.  A massive howl of shock, anger, and blind hatred explode from pretty much every corner of the planet?  Will we be bowing down to our new overlord Russians in the street?  Or will Russians be strung up from lamp-posts in retribution unleashing this terror on the world?  I’d guess (sadly) lamp posts…

Absolutely no-one is going to do anything but stand up and condemn that act.  Especially because it this is seen as a war of Russian aggression.  There isn’t even a “self-defense” angle.

• Anyone on the sidelines (China, India, Iran, Global South) will have to move forcibly against Russia.
• Anyone in the fight (the West) will have a blank check to do whatever they want against Russia.
• Russians themselves – elites and ordinary folks – will have to decide if they really want to go down with the madman in the bunker.  Or join him in the Hague for what might the Criminal Court’s first and only sentence of capital punishment…

So if Russia goes nuclear

• any and every military unit outside their borders (including everything in Crimea which is legally Ukraine under international law – so the Black Sea Fleet) is probably vaporized by the US shortly thereafter. ALL the troops they have in Ukraine and Syria are open game.  We will do it to send a message to anyone else dumb enough to try it.  Russian assets on the high seas is a little more tricky but…
• China and India will have to impose sanctions at minimum. There will be no more market for Russia’s oil at any price.  There will be no more goods sold to Russia at any price.
• Most important, EVERYONE in Moscow will realize they are either staying on the side of the “single most hated man in the world” or getting on the side of “the rest of humanity.”  If Putin tries to subsequently order more nuclear strikes, he can have ZERO confidence people will carry out the orders.  Hitler in the bunker couldn’t be sure his orders were going to be carried out.  And Putin doesn’t even have anyone knocking at the gates of Moscow to stiffen their spines….

Putin ends up with even less military power, the choice to retaliate/escalate against NATO (not gonna happen and he lacks the weapons), no tactical advantage (there is no strategic choke point in Ukraine) and potentially a nuclear cloud rolling towards Moscow.  If he orders one or more nuclear strikes, he risks precipitating a coup.  With no place on earth (literally) than could offer him shelter.  His next stop is the Hague or the grave.

In short “tactical nukes” are a branding exercise.  The most toxic brand you can imagine.

We likely get a decisive outcome in Ukraine in the first half of 2022.  This is probably the biggest economic/political “surprise that shouldn’t be one” in store for 2023.  A lot of people seem to be assuming a “continuing stalemate.”  But there is no stalemate even now.  The Russians have been losing since March 2022.  They have no path to anything you might call a victory.  Ukraine does.

Can Ukraine can break through and decisively end the war?  We don’t know.  They do have a pretty good shot at it in the next 6 months.  As in the past, Ukraine will keep wearing down the Russians supplies and hardware.  They likely mount another offensive in February/March ahead of mud season.  If they get lucky, they end the war.  If not, they consolidate their gains, start grinding Russians logistics again, and prepare for the next offensive.  That has been their (successful) pattern since last summer.

Putin has no good options to respond.  Unless he pulls a real rabbit out of the hat, he is just in denial and/or praying for a miracle.  His first army collapsed over the summer.  The conscript army he rushed in to replace it is dying in droves and utterly incapable of taking the offensive.  His next conscript army will fare no better.  In the meantime, he is running low of tanks, missiles, and artillery shells.  Once those are gone, he will have nothing.  We could see a mad lunge towards Kyiv from Belarus.  That likely fails.  Attacking is hard with well-trained troops much less a rabble.

The West sees this.  They are doubling down on a Ukrainian victory.  In the last few weeks, France, the US and FREAKING GERMANY?!?! have broken the “no armored vehicles” taboo.  The US and FREAKING GERMANY?!?! are sending Patriot missile batteries.  When gutless Germany starts showing some backbone, you know they see a Russian defeat as good as done.  They are playing for a (late, unearned) spot in the victory parade. Also, everyone (especially German chemicals giant BASF) would like the natural gas taps turned back on before next winter…

The end game remains uncertain.  We are waiting for the next Ukrainian move.  Putin has lost the initiative.  His only hope is Ukrainian (and Western) exhaustion.  But the West can keep the pot boiling for at least another 6-12 months.  Russia might not make it another three months.  So the outcomes are…

1. Ukraine’s luck runs out.  Their next offensive fails.  Past attacks have precipitated Russian collapses – Kyiv, Kharkiv, Izium, Lyman, and Kherson.  But Russia’s lines a shorter and maybe Ukraine doesn’t break through this time.  We end up with a “frozen conflict.”
2. Putin’s shabby, under-supplied conscript army collapses yet again.  He loses now have lost most/all of the territory taken in February 2022.  He also risks a bigger collapse of morale, will to fight, etc…

Putin’s best hope now is a “frozen conflict.”  Hang on grimly while he rebuilds his weapons stocks and chips away at Western unity.  Unfortunately, Western unity looks pretty un-chipped.

On the ground, Putin is stuck.  He can’t move forward.  He can conscript more men.  But he can’t make more artillery shells, missiles, or tanks.  The vast post Soviet stockpiles are squandered.  Untrained conscripts can (maybe) hold ground.  They are never going to manage any sort of real combined arms offensive.

Putin could also retreat any time.  But he obviously feels that isn’t an option either.

So Russia sits in stasis.  Burning down its dwindling stock of shells because it is in a (great new word from 2022!) Zugzwang.

1. What is Zugzwang in chess?  Zugzwang is a German word which basically means, “It is your turn to move, and all of your moves are bad!” There is no “pass” or “skip a move” in chess, so sometimes having to move can lose the game! 

Ukraine’s challenge is to find a weak spot to break through.  The Russian lines are shorter, so the weak spots are probably less obvious.  But, if they can break in behind the Russians, we will see another headlong Russian retreat.  The other risk is Russia might be getting better at retreating.  They did a pretty good job getting out of Kherson intact.  But every and any retreat always risks a collapse.

The other uncertainty is whether that collapse remains local or becomes general.  So far, Russia has been able to fall back and stabilize.  BUt one of these days the troops will just keep running.  They would certainly stop at the Russian border, but that is a clear loss.

So that’s where we stand.  Not a lot of movement.  But definitely not a stalemate.    And Russia is still losing.

The first rule of Fight Club is: you do not talk about Fight Club.

Reading the financial press and the freaking New York Times, you would think the only variable in the inflation equation is labor.  “We must see unemployment go up to fight inflation…” is stated as some sort of law of physics.  It is not.  It is an artifact of the stone dead Phillips Curve (see Fed paper below).

Inflation is “prices going up.”  The variable in a price equation are Desired Profit Margin + Cost of Materials + Labor Costs + Capital Costs = PRICE.

Labor is the only “acceptable” variable because we must never, ever EVER talk about “Desired Profit Margin.”  Even though profits are at all time highs (see Fed Data below).

I’m not making a “political” argument here.  Just a practical one.  Per the FRED chart, profits are a pretty variable and relatively fast-moving.  If something in that price equation is going to give, it is more likely to be profits than (sticky) wages.

The pandemic did wonders for profits because discounting disappeared.  Profit margins are still hanging at those pandemic-level highs.  There’s a pretty decent chance margins are the last pandemic-era domino to fall – going the way of Zoom and Peloton.  See the FRED chart below and forecast out one year – up, flat, or down?.

Wages are sticky and slow to adjust.  We also have a labor shortage out there.  You gotta keep paying people to produce.  There aren’t a lot of people to hire.  So you gotta sell on thinner margins.

But why can’t consumers just keep paying current prices?  Because their spending depend on their income – their spednign depend on the “labor” share in the Price equation above.   The USA took an average 2% pay cut in 2022.   Wages are up ~5% on average versus ~7% inflation (so a 2% drop in purchasing power).

That 2% cut has to come out of something eventually (after the pandemic era savings are gone).  It is most likely to be profits.

What if we really did cut back on labor and create the unemployment “everyone” sees as necessary?  Even fewer people will be able or willing to pay current prices.  Profit margins still go down on slowing demand.  Slowing employment only makes the profit problem worse.

This is not good for S&P500 earnings.  Companies with pricing power will do OK.  Companies that have been milking a period of unusual profitability in more competitive markets will do badly.  Companies selling durable goods (which sold big during the pandemic) are facing a nuclear winter.   When is the reckoning?  No idea.  But it isn’t going to be pretty for a lot of sectors.

Key point is that, in all this, wages and employment probably take less of a hit than people expect.  Mostly because falling profits and falling prices solve the inflation problem before wages do.  Sales hold up OK using the labor on hand.  It just gets tougher to turn a profit.

Corporate Profits After Tax (without IVA and CCAdj)/Gross Domestic Product – https://fred.stlouisfed.org/graph/?g=1Pik 

Fed Paper – Who Killed the Phillips Curve? A Murder Mystery https://www.federalreserve.gov/econres/feds/who-killed-the-phillips-curve-a-murder-mystery.htm

Is the Phillips curve dead? If so, who killed it? Conventional wisdom has it that the sound monetary policy since the 1980s not only conquered the Great Inflation, but also buried the Phillips curve itself. This paper provides an alternative explanation: labor market policies that have eroded worker bargaining power might have been the source of the demise of the Phillips curve. We develop what we call the “Kaleckian Phillips curve”, the slope of which is determined by the bargaining power of trade unions. We show that a nearly 90 percent reduction in inflation volatility is possible even without any changes in monetary policy when the economy transitions from equal shares of power between workers and firms to a new balance in which firms dominate. In addition, we show that the decline of trade union power reduces the share of monopoly rents appropriated by workers, and thus helps explain the secular decline of labor share, and the rise of profit share. We provide time series and cross sectional evidence.

FYI – My New Year’s resolution was “stop sending individual e-mails to individual people when the content is really a perfectly good blog posts.” So I’m going to experiment with more frequent, shorter, and probably less well edited posts 🙂

A friend asked me about recent US noises about Ukraine and Russia coming to a negotiated solution.  I figured I’d write it out here.  So what does this tell us?

We are NOT going to see an “appeasement” peace.  A Russian retreat back to pre-war lines would be the absolute minimum offer on the table.  As a simple example, Russia would have to give back Mariupol, Melitipol, and all the other territory it took this year.   Everyone in the West understands we can’t have another Munich.  Whatever result will have to be (and look like) a Russian defeat.

Putin likely won’t (yet) accept the offer on the table.  He is still trying to exit this conflict with some face-saving win.  Keeping Mariupol, for example.  Otherwise, he’d prefer to shift to a “frozen conflict” with static front lines.

The Ukrainians will do all they can to prevent a frozen conflict along a static front line.  They have a window here to 1),  recapture territory.  2).  degrade the Russians further (which the US will be happy to keep funding).

1. They will keep punching.  Keep the war hot.  They punched through Russian lines around Kyiv, Khakhiv, Lyman, and now Kherson.  The next punches could be towards Mariupol or Melitipol, but also through Luhansk or Donetsk (cutting off Mariupol and Melitipol).
2. Those punches will aim to open a path into Crimea.  I don’t even have an armchair general guess at what that looks like on the ground.   But Ukraine wants Crimea back.  They understand they can’t take it by slow siege.  They either take it in the next 6-12 months or (likely) not at all.

So the War will still go on (for a while).  Into 2023, but not beyond.

• Putin still can’t/won’t accept the minimum peace offer the US would put on the table.
• Ukraine will be grabbing back as much territory and destroying as much Russian hardware and (trained) troops as it can.  Untrained conscripts are a truly sad but necessary part of that killing, but Ukraine and the US are after the officers and NCO’s.
• The US will keep funding the war (for a while)

The question is when Putin (or his successor) is willing to accept a “no appeasement” peace.  That is hopefully sometime in 2023.

The US “peace” noses mostly tell us two things.

The US is feeling close to achieving its war objectives.  These are…

1. …the destruction of the Russian military as an effective fighting force
2. …Russia’s permanent relegation to 2nd tier power status.

The US is ambivalent about duration – not signing up to…

1. A long drawn-out, “high intensity” war in general.  A frozen conflict is OK, but we can’t keep this pace up indefinitely.
2. A bloody, grinding Ukrainian push into Crimea specifically

What about Ukraine’s objectives?  Ukraine’s objectives are more expansive.  They want Crimea back.  They desperately want to avoid a frozen conflict hobbling the country for the next 10 years like it did the last 10.  They also want a genuine invitation to join “the West” – with all the economic and security benefits this implies.

Full membership in Europe and the West is probably enough for now.  Ukraine has paid enough in blood to deserve it.  If Ukraine gets rich fast enough, Crimea will eventually be begging to re-join it…  Lets just hope they don’t corruption their way out of a golden opportunity.

Ukraine also understands its artillery shells now come from the US, so they understand the limits to their ambitions. I’d guess those limits are measured mostly in time (months, not years) and somewhere around the Crimea border.

We aren’t going through an “inflation” so much as a collective impoverishment.

• Prices are going up.  The October CPI was 8.11%.
• Wages are not keeping pace with prices.  Wages in September grew 6.3%, slowing down after a peak of 6.7% in August.  Per the Atlanta Fed’s excellent wage tracker.

So we are a couple of percentage points poorer relative to last year.  It really is that simple.  A recent Bank of England explains the dynamics quite nicely.  The details are UK-specific, but the general points apply anywhere prices are rising faster than wages.

for given GDP, rises in the relative prices of goods and energy make us collectively worse off. And that’s exactly what’s happened over the past couple of years, thanks first to the pandemic and then Russia’s cut in gas exports. Over that period the price of the UK’s imports has risen by 20% more than the average price of its output….

As a result, real income for the non-North Sea economy as a whole – how much our collective output is actually worth, in consumption terms – has fallen by over 5% since the end of 2019.

Here is where inflation kinda sorta kicks in…

It’s understandable, faced with this extraordinary squeeze, that people and firms in the UK economy have sought to protect their real incomes – whether pay or profits – through compensating rises in wages and domestic prices. Unfortunately, and at least collectively, those efforts will not make us better off. It’s not as if one group or sector is worse off only because another, within the (non-North Sea) UK, is better off. The rise in import costs has depressed the purchasing power of the country as a whole. So all that can be done is to shift the losses from one place to another.

So what can the Fed (or the UK’s MPC in this case) do about it?  Not much.  He makes an argument for slowing the economy further to keep inflation expectations anchored.  But that amounts to accelerating the economic slowdown being driven by prices going up faster than wages.  If the Central bank does nothing, the economy will still slow down.  Because stuff got more expensive.  So we buy less stuff.

Monetary policy cannot undo the hit to real income. Nor could it ever have done. One often hears that people are worse off “because of inflation”. This is not quite right. Implicitly, it presumes that monetary policy could have prevented prices from rising so fast without doing anything to nominal incomes. Unfortunately, that’s not the case. Even assuming policy had been tightened sufficiently aggressively, and sufficiently early, to have knocked eight percentage points off the current rate of inflation, it would also have depressed nominal income growth by at least as much and almost certainly quite a bit more. Unemployment would be materially higher and nominal wage growth materially lower. Ultimately, this reflects what is known as the “neutrality” of monetary policy: in the long run it has no impact on real economic variables (things like real output or relative prices). It can’t boost structural productivity, for example. Nor can it offset the consequences for real incomes of (say) disruptions to supply chains in Asia or Russia’s curtailment of the supply of gas to Europe. Indeed, in the first instance, at least for a period of time, tighter monetary policy lowers GDP and real incomes. I will say more about this shortly. For the time being, a better short-hand description is this: the pandemic and the war have led jointly to higher inflation and lower real incomes; the MPC will ensure the inflationary effects do not persist into the medium term; but the real-income hit exists either way, and will be reversed only to the extent the underlying shocks themselves go away.

Putin has just doubled down on his “madman” negotiating strategy.  The problem – for Putin especially – is that strategy gives him low odds for a face-saving negotiated outcome.  In bar fight terms, the madman eventually ends up getting kicked to a pulp – maimed or dead.  Putin’s chosen strategy looks headed towards “pulp.”

2 side notes first:

1. Putin faces re-election in 2024.  Yes, they still hold elections.   Public opinion still matters.  Putin needs money in Russian pockets before they see even a rigged ballot box.  Where will he get that money?  By turning the European gas taps back on in 2023.
2. Putin “mobilizing” 300,000 troops today will change nothing on the ground for at least 6-12 months.  Even after that, it won’t change much.  Moreover, the Russian army likely can’t hold its ground for 6-12 months or maybe even 6-12 weeks.

Putin is doubling down on his “madman” strategy.  Convince everyone you will stop at nothing, hoping they will back down first.  Shut off Europe’s gas.  Declare a partial mobilization.  Threaten nuclear strikes.  Plan referenda in occupied regions of Ukraine.

All this doubling down is consistent with game-theory’s madman strategy (as well as a clear sign of increasing desperation).  His hoped-for end game is cooler heads will prevail.  Someone steps in to break up the fight.  Putin wins a face-saving exit into a frozen conflict.  He lives to fight another day.

The madman strategy works best in a one-round game.  Some stranger is credibly threatening to “go nuclear” on you.  Your smart choice?  Cool things down and walk away.  Life is precious.  He may well be crazy.  You won’t cross paths again.

In a multi-round game, the madman strategy will eventually fail catastrophically (for the madman).  Geopolitics is a multi-round game.  Putin may be at that end game.

Think about the Ukraine War as a bar fight.  A lawless part of town.  A tough crowd of mostly regulars who show up every Friday.

• Big Bully Bill gets in the face of Shrimpy Sam.  Sam “should” back down.  Bill “should” let him.  That’s how the game is usually played.  That was most people’s expected outcome up until Feb 24th. Same old Friday night.
• Big Bully Bill keeps pushing…  He throws a few punches.  Its a real fight now.  Whoa Nelly!  This is a thing now!  A space clears and a crowd gathers.
• Big Bully Bill was never too coordinated to start with. He is also sloppy drunk.
• Shrimpy Sam has been taking karate lessons.
• Some awkward stumbles and a few lucky whacks later, Shrimpy Sam has Big Bully Bill on the floor.  Kicking him with steel-toed work boots.  Things are starting to get ugly…

In a normal multi-round game, this is when “everyone” intervenes to cool things down.  The bar crowd steps in.  Pulls Sam aside – stop kicking before you really hurt the guy.  Shake hands and call it over.  Let Bill slink off.  Lesson learned.  Lets all get back to drinking.

But that wont happen with this particular bully in this particular bar.

Big Bully Bill has played the “madman” card one too many times.  “Everyone” knows that Big Bully Bill can’t be trusted.  He might shake hands, but he can’t credibly promise to walk away.  After multiple rounds of playing the madman card, no-one trusts he’ll hold up his end of any bargain.  Too many prior threats to come back and shoot up the bar.  Too much history of knifing some prior antagonist after his back is turned.  Bill’s word of honor has no value.

Sam, Bil’s frequent victim, knows this better than anyone.  So he’s going to keep on kicking while he’s down.  His end game is “if I maim Bill, he won’t be able to move fast enough to get a knife in me next time.  If he up ends up in a coma, all the better.  This is life or death for me (and the cops never come around this part of town anyway).”

Even worse (for Bill), the whole bar supports Sam’s end game scenario.  “We’re all pretty sick of Bill.  We all honestly worry he WILL actually shoot the place up one day.  He’s also a jerk.  So we’ll turn a blind eye.  Maybe even a lend a hand when it comes time to dump Bill’s limp body in some abandoned lot.  No-one’s gonna miss him except Xi and he’s been kind’ve a jerk lately too… 

So the 100% rational solution for everyone is Sam kicking Bill into a bloody pulp.  Until Sam is too winded to kick anymore.  Then dump Bill out in the cold.  Whether Bill wakes up maimed or dead, it means peace and quiet next Friday night.  So they just let Sam keep kick kick kicking.  Its a bad result for Bill.  But he chose that end game when he chose that strategy.

This is just multi-round game theory.  Fool me once shame on you,  Fool me twice shame on me…  The “madman” strategy pays off until it doesn’t.  Especially for an untrustworthy madman.

Putin is now down on the floor.  He is doubling down on his madman strategy.  Hoping the threats will spark an intervention.  But the kicks keep coming and his erstwhile friends (China and India) are edging towards the exit.

The Ukrainians stopped talking about negotiations months ago.  They are going to do as much damage as possible while they have the advantage.  They will keep kicking until their strength gives out.

No rational bystander will or should intervene.  They know Putin won’t hold up his end of any bargain. They know the threats are hollow (including nukes – that’s for another post).  If anything, they get in a few kicks themselves.

In this end game, does Putin end up maimed?  If so, how maimed?  Does he end up dead?  Is that politically or literally?  I have no idea.  We know he’s losing control – caught in the end game of his own madman strategy.  We just don’t yet know where that end game actually ends.

——————————————-

All of the above was sparked by a recent back-and-forth with a friend.  Figured I’d append it.  He’s a thoughtful smart guy, so I’m just cherry picking his words to set up a straw man.

There is zero energy being placed in getting a negotiated solution…that’s what is needed now…Putin needs an out… Ukraine needs to stop.  And Europe needs some gas.  There will be hell to pay if no settlement is agreed.  No politician…not usa, british, german or French is getting that message….they are all still going for broke.

My reply (amended):  Somewhere in 2023 we get a “negotiated” settlement that the might as well print out and sign on a roll of toilet paper.  The real guarantor will be how depleted and demoralized Russia’s military is.  A frozen conflict because Russia is unable to prosecute it further, not because of a signature on a piece of paper.

Putin can’t be allowed to negotiate from a position of strength.

Everyone cuts a deal to get the gas flowing again, but Putin will need it more than Europe will.   He will be dealing from a weak hand.  The semiconductors and other advanced systems supplies he needs to re-build the military will stay sanctioned and thus expensive.

Key assumption being made by many (not you) is that Putin – the genius 3D chess master with an iron grip on his country – can afford to keep the oil and gas taps off.  Maybe this is true but I don’t think so.  Not without some hard, counter-intuitive analysis of how the Russian economy fares under that scenario.  Most indicators I’ve seen show Russia’s economy in bad shape and getting worse fast (e.g. recent FT article on budget tipping into deficit).

The “iron grip” perception is also questionable.  If Putin really has that control, why hasn’t he (really) mobilized the country for a proper war? Why has been trying to prosecute a “special operation” with such disastrously limited manpower long after it became obvious more troops were needed sooner vs later?  He is ruthless, so why hasn’t he taken that step? What is he afraid of?  The most likely answer is Putin is not nearly as confident in his grip on power as a lot of Western observers are of it.

So is Putin really able to follow through on sustained oil and gas embargo of Europe? Who is more desperate? Europe? – sitting on 80% gas storage already with other levers to pull like that huge gas field in the Netherlands. Or is Putin – desperate to get the gas/oil/money flowing again before the 2024 election and so that he can distract his populace when Ivan comes marching home soundly whipped? After images of the Russians who moved to Crimea evacuating on boats because the Kerch straits bridge is blown? etc etc

I think the gas is flowing again by 2023.  With the Russian military out of commission for at least 5-10 years.  Hopefully long enough to outlast Putin.

I keep running into a lazy consensus around Ukraine – a long, grinding war prosecuted by implacable, iron-fisted Putin pressing crushing energy sanctions until…? The end game is usually hand-waving about “negotiations” that largely assumes Ukrainian capitulation.  If those ill-examined assumptions proves wrong, how much will it upend markets?  Because the evidence suggests that consensus scenario is wrong.

So what happens if Russia’s energy and consumer goods flows re-start?  That is not in most 2023 forecast expectations I’ve seen.

• Russia’s energy flows flood back into global markets.  European and global gas prices plummet.  Oil prices likely drop too.  Those price changes will positively impact everything that depends on energy (real-economy inflationary) and negatively impact mathematically measured inflation (nominally deflationary).**
• A re-start of Russian consumer imports from the West.  Russia’s pre-war economy was the same size as Spain, so this won’t move the needle much.  But a lot of Europeans – no longer paying an oil/gas war tax – will shift spending more on other stuff.  So the global effect will be solidly positive (thus inflationary).

The “hot” war will likely last months.  Definitely not years.  Only an armchair general could expect humans and machines to keep up this tempo.  The rate of equipment loss/depletion is too high.  Although human morale – depleted by time and the equipment running down – probably cracks before the hardware does.  As the last weeks show, the Russians can’t hold their lines with the men/equipment on hand.  So the Russians probably lose heart before the Ukrainians do.  Neither can keep up this pace indefinitely.

Per my prior post, the end game is (hopefully) a frozen conflict that stays cold(ish) until past Putin’s sell-by date.  In that transition from hot war to frozen conflict, Putin is most likely to move towards re-opening the gas taps.

Putin has to be desperate to re-open the gas taps.  Why?  Putin needs the money!  Public opinion still matters in Russia (as it also matters in China and even – gasp – North Korea).  How does Putin distract Russia’s attention away the strategic and military disaster of Ukraine?  Engineer a consumer boom.  Data are hard to come by, but Russia’s non-oil/gas consumer/producer economy is losing altitude fast.  Putin can’t risk an economic tailspin in 2023.  Putin needs money to spread around.  He especially needs to re-start imports of stuff like iPhones.  The last thing he needs is a humiliating defeat and a tanking economy.

The West won’t push back on gas or oil.  Everyone wants to get back to business.  A struggling Europe will jump at economic normalization.  The US will go along; Lifting consumer sanctions;  Keeping Russia’s defense industries restricted (especially chip supply).

Obvious, accessible facts point to the scenario above.  It is not guaranteed, but its a lot more likely than a long grinding war/embargo.  That market consensus seems to rest on  some unusually lazy assumptions?!?

1. Russia is still the Cold War bogeyman that haunted the childhoods of anyone over 40-50?  Russia is an obviously mis-managed economic basket case outside of its (foreign technology dependent) oil, gas, and commodities sectors.
2. Russia is still a military super-power?  How does this belief hold up against the abject reality of the past 8 months?  I have no idea.  But this shibboleth keeps shambling through conversation after conversation.  Often accompanied by a hand-waving well they have nukes.  With no follow-on thinking about where/how Putin could actually drop a nuke that would help his position tactically or strategically.  Do you really think China would or could just let that go by?  Putin is smart enough to know nukes are a fast path to personal disaster for him.
3. Putin is some sort of James Bond villain – and iron willed master strategist in absolute control of unthinking minions?  The real Putin is the mafia boss of an unruly mafia state.  How much absolute power is wielded by anyone in the Godfather movies?  Putin’s reality is a lot closer to that swirl of negotiation, maneuvering, double-cross, and occasional outbreak of fratricidal violence.  Goldfinger or Blofeld might keep sending waves of minions to their death.  The Godfather would be nervously looking to end this misadventure and get some walking money in capo’s pockets before it brings down the family.

I expected a short war before the Russians’ headlong retreat from Kharkiv.  I expect that scenario to replace the lazy consensus over the next few months.  I’m not certain how much that will impact markets.  It might be already priced in – explaining some current market behavior/pricing conundrums more than it changes anything.   It will, however, force a lot of people to re-think their outlook.

** Energy prices are best seen as a tax on economic activity.  So an energy price increase is akin to a tax increase.  A decrease is like a tax cut.  Energy’s impact on inflation is thus counter-intuitive.

• Lower energy prices imply “deflation” in YoY prices, but they give an  inflationary boost to the real economy.
• Higher energy prices increase measured inflation, but they are a deflationary drag on the real economy.

The above never gets mentioned in the business press.  But it is an intuitively obvious dynamic accepted by mainstream economics.  More on that later.