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Wednesday, March 19, 2014

Nuclear Weapons & Monetary Policy

The news from Ukraine and Crimea remains worrisome, yet there has been limited reaction from markets. Although this could ultimately prove to have been too complacent, there is very good historical precedent for this behaviour. Post-1945 international relations have not been entirely peaceful, yet the scope for conflict is limited by the reality of nuclear weapons. Historical analogies drawn from earlier eras do not apply, at least for relations amongst the countries that are protected by a nuclear umbrella.

Despite my last name, I have no particular insight into Ukrainian affairs (other than the fact that I can cook perogies). My grandparents left the region about a century ago, and the family did not look back. In particular, I do not have an opinion on what the outcome should be.

When considering foreign policy, one key observation has to be kept in mind: no two nuclear-armed countries have had a serious direct military conflict. There were proxy wars during the Cold War where "advisors" from one side aided forces combating the other side, and there have been "accidents" along the India-Pakistan border. However, regular military formations have not met in combat. This rule held during the Cold War, and there is no reason for military doctrine to change, even if the clash of ideologies has waned since the fall of the Berlin Wall.

As a result of this history, I usually ignore geopolitical analyses that fret about the rise and fall of relative GDP ratios, and how international relations will become complicated due to rising powers. No matter what the economic situation is, no sane policy maker is going to pose an existential threat to a nuclear-armed power.

For bond investors, this is a dramatically different situation from the pre-World War II era (or for present-day countries not under the protection of a nuclear power). In those environments, the future existence of the country you are lending to is not guaranteed, nor was your ability to collect. Investors had no choice but to study geopolitics carefully.

Returning to the current situation, my reading of the situation in Crimea is that the Russians can plausibly argue that developments there could pose an existential threat to their country. This takes direct intervention by others off the table.

But an economic conflict is possible, in the form of sanctions. Selective, ceremonial sanctions are already under way, and could continue without any really effect. The real question is whether they could escalate to take the form of a stoppage of the flow of oil and natural gas from Russia. Such an outcome would have extremely dramatic economic consequences, even if the stoppage was short, due to the shock to confidence.

My quick-and-dirty analysis is that this would be too dangerous to the euro area economy for such an escalation to be contemplated by Western policy makers. The euro area periphery is already in a state of depression, and the fiscal strains within the fixed exchange rate regime are already enormous. As a result, my guess is that this gives markets a good reason to be complacent.

We are once again operating under conditions of uncertainty, and not randomness, a distinction emphasised by Keynes. Those of us who are removed from area of conflict have no choice but to continue commercial activity under the assumption that current conditions will persist. This is even though we know we are on the edge of a chasm of an unknown depth, and we do not know exactly what could cause us to slip.

(c) Brian Romanchuk 2014

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