Russia Sanctions Trade Shock: Fulfilling the Fears of Smoot-Hawley?

Russia Sanctions Trade Shock: Fulfilling the Fears of Smoot-Hawley? 1

Before getting to the topic matter of this post, the potential for a sanctions-induced trade shock, we need to separate the state of the war in Ukraine from a military standpoint from the state of economic sanctions. We had pointed out from the outset that Putin had set forth objectives for Russia that had significant tensions that arguably rose to the level of contradictions.

Specifically, Russia was not going to occupy Ukraine or impose government against local will. That was almost certainly code for allowing ethnically-Russian dominated regions, certainly Donbass and potentially much more of Eastern Ukraine, to either cede from Ukraine in a Kosovo or Crimea-type process or have much more regional autonomy, as envisaged in the Minsk Protocol. Russia was going to demilitarize Ukraine. Depending on the level of reduction of capability, that goal did seem attainable with a relatively short war.

However, the third aim, denazification, was a very tall order unless Russia sought only to remove the most prominent perps (it had a list of names it intended to round up and put on trial) and members of the military it captured (neo-Nazi tattoos no doubt make for an easy first cut). Recall that the Russian army made clear that any soldier who put down arms would not be harmed.

A final objective, not stated by Putin but clearly a boundary condition for the campaign, was to limit civilian casualties and destruction of non-military infrastructure.

Russia has run into its constraint of trying to wage a surgical war. As other commentators have pointed out, the Azov Battalion has succeeded in infiltrating enough of the Ukrainian army so that securing some troop surrenders appears not attainable. Mind you, that may not be due to the depth of conversion but the reality it only takes a hard core loyalist or two in a unit to assure that any deserter would be shot. And penetration across the military also complicates the denazification process.

But as we’ve seen, and is not well reported by the West, the Ukrainian army has been moving equipment and personnel into residential areas, thus making it difficult for Russia to take holdout cities without harming civilians (although there is the question of the accuracy of Western reporting. While Russia is certainly killing civilians, that’s typical “Shit Happens” in combat. The claim that Russia is singling them out is unsubstantiated). And Russia appears to have underestimated the increase in professionalism of Ukraine’s army since 2014 due to NATO training.

Interestingly, former British civil servant David doesn’t see these difficulties as fatal:

Western liberal thinking sees wars “breaking out”, for various, hotly debated, reasons, followed by peace initiatives, ceasefires, attempted peace treaties, final settlements, treatment of “underlying causes” etc. That’s not on offer here, any of it.

This is a war, albeit limited, undertaken for specific strategic reasons, and with specific objectives. It won’t be over until the objectives have been reached. Even if some kind of compromise were possible, it’s doubtful whether the Russians would accept it. The crisis was twenty years in the making, and what the Russians are trying to do is to re-draw the map of the region, and remodel the security structures of Europe, for the foreseeable future. We are so used to thinking in news cycles, re-election cycles and so forth that we cannot cope with a long term plan. The Russians are thinking twenty-five years ahead, and essentially they are prepared to take whatever time is needed now, and whatever pain is needed now, to accomplish their goals. They may well be expecting sanctions to last in some form for years, they may have to cope with a low-level insurgency in the Donbass, but they appear to have judged that, in the long term, they’ll be in a worse situation if they don’t act than if they act. But we can’t understand that.

Now to the economic discussion.

The disconnect between the Administration and the Beltway power players versus mainstream Americans is large and seems destined to grow. The US press and Democratic party officials are intent upon, and even gleeful about, punishing Russia through sanctions, since they feel compelled to Do Something while not being willing or able to make interventions that might make a difference to the battle outcome.

European officials are more sensitive to the risk to their economy, with Germany, Romania and Hungary not joining the US appeal last week for tougher sanctions on Russian energy (recall the partial cutoff from SWIFT exempted commodity transactions, particularly energy).

The rhetoric and punishments escalated last week even as signs of real economy costs in the West mount, along with warnings of greater harm if there is no relaxation soon.

Americans are noticing the impact of higher fuel prices even before they have worked their way much through the economy via 1970s-style energy-induced price increases of goods and services. But they are starting. For instance, Uber has just imposed a fuel surcharge.

We’ll discuss an outcome that does not appear to be sufficiently on the radar of economists and politicians: that of a trade shock, where the impact of sanctions-induced shortages and sharp price increases produce “the whole is greater than the sum of the parts” levels of profound economic damage. Mind you, this outcome is not baked in. Spitballing, I’d now put the odds at only 20%. But this situation bears watching. Given the complexity of trade and globalized manufacture, combined with the business press focus on financial markets over real economy nitty-gritty, we very much hope readers with technical expertise and/or a front row seat on industry conditions pipe up on this post and on an ongoing basis.

Caveat: The West May Relent as Costs of Sanctions Become Visible and High

Western leaders may soon find a way to better square the circle of seeming being tough on Russia without producing much self harm.

That concern did play into the initial sanctions, where the partial SWIFT ban was designed to be mighty leaky so as to allow the West to continue buying Russian energy. But apparently no one bothered understanding how oil exporting works. For instance, the financial sanctions resulted in banks not being willing to issue letters of credit used to protect buyers. No letter of credit more or less means no paying for shipments, which means no shipments.1 A few Russian tankers have nevertheless docked post-sanctions and have discharged their cargo. One wasn’t flagged as a Russian ship and sort of does not count; I’m curious as to how the others navigated both the prohibitions at ports and the letter of credit impediments.

The point is that the initial sanctions weren’t as surgical as the US and Europe believed.

The blowback has gotten worse as private companies have piled on with their own restrictions and the US has upped the ante, first by banning all Russian oil, and then by enlisting the G7, with the hope of the rest of the WTO following, to end Russia’s favored nation trading status.2

Yet the Democrats were already set to face big losses at the midterms. A spike in gas prices alone could turn a defeat into a rout. We noted at the time that Biden’s eight point bounce at the start of the war was pathetic by historical norms of 20 to 25 points. And it’s eroding mighty fast. The Hill confirmed our take over the weekend:

Biden is not benefiting from the American tendency to rally around the president in times of crisis. Biden’s small polling bumpfrom the State of the Union address is unlikely to be the beginning of a trend. The combination of bad underlying numbers, high probability of a worsening situation in Ukraine and a Democratic coalition constantly at odds with itself sets up Biden and the Democrats for worsening numbers heading into the November mid-terms.

And that assessment oddly doesn’t include the elephants in the room of worsening inflation and good odds of yet another Covid spike. Democrats may get the wake-up call from a March 8 poll that shows Trump narrowly beating Biden in a matchup.

A colleague who is well networked with Democratic party insiders is strongly of the view that the Administration can’t risk inflation accelerating and will have to back down on Russia sanctions. But it’s hard to see with the press piling on with Russia demonization how Biden can back down, particularly after having been charged with blowing the Afghanistan exit. And Republicans have found a way to weaponize the energy price hikes, by not making it about the sanctions but rather the Administration’s failure to achieve “energy independence”

In the UK, pols are discussing the need to soften the impact of an energy price shock on the poor. From the Guardian:

Some of the poorest people in the UK will “simply starve or freeze”, as a result of rocketing energy prices, consumer expert Martin Lewis has warned, as he urged Rishi Sunak to take action in his spring statement.

Lewis said energy bills for an average household, already set to rise to £1,971 in April, could hit £3,000 in October, when the regulator Ofgem next sets the price cap. “That’s my conservative guess: not the worst case,” he said…

“When you start to have absolute poverty… then I think you have to get to the point where you have to question what the impact on wider society is, because you know that extreme poverty causes civil unrest,” he said…

The chancellor announced a package of measures last month to soften the blow of surging energy costs, including a £150 council tax rebate for homes in bands A to D, and a £200 discount on bills in October, which will be repaid with higher bills in future years.

Sunak is holding the line against making that scheme more generous when he gives his spring statement on 23 March. Lewis – who has been critical of the £200 rebate, which he calls a “loan-not-loan” – urged him to go further, given the renewed increase in prices since Russia’s invasion of Ukraine, which will feed into the October energy price cap….

Lewis… argued that the chancellor’s first priority must be “those people who will simply starve or freeze because of this. And that is not exaggeration”.

The short version of the current state of play is that while Russia was hit immediately with the financial consequences of the sanctions, such as the plunge of the rouble, the freezing of hundreds of billions of central bank reserves, the cutoff of Visa and Mastercard from external transactions, the West in fairly short order was feeling the cost of higher energy prices. And those are only starting to work through their economies.

Possible Trade Shock; Shades of Smoot-Hawley?

There isn’t a clear cut historical example of trade restrictions driving global-level economic dislocation.

I’m of two minds in mentioning Smoot-Hawley Tariff Act, which were protectionist tariffs, signed into law in 1930, which quickly led to retaliatory tariffs. Economists for the most part have abandoned the view that Smoot-Hawley caused the Great Depression; the more careful analyses also reject the weaker formulation, that it made the Depression much worse. The demand shock of the stock market crash and widespread bank failures almost entirely explain the collapse of trade.

But the great eras of internationalization were not the Roaring Twenties but the runup to the Great War and our contemporary globalization of manufacture.

Our system of trade is so complex that it’s a classic case of obliquity: no one can map its operations, so that it’s impossible to devise efficient interventions on a macro basis. But a general rule (hence the name obliquity) is that in highly complex systems, a seemingly straightforward approach is much less likely to succeed than an indirect one. So if we start having large-scale problems, the officialdom is unlikely to be very successful in intervening.

The reason the risk potential is large is that traded products have become critical o all advanced economies. Yet that exchabge is fragile thanks to widespread adoption of just-in-time inventory practices and the vogue for large companies to reduce their number of suppliers so as to increase their bargaining leverage. That means the potential for cascading problems is considerable. We got a taste of that with Covid supply chain issues. Imagine that happening in merely 25% of the products that depend on commodities where Russia and Ukraine have significant market shares. It’s hard to think of an industry that would be spared.

I’ve had economists argue that any trade shock be a one-time, mot terribly long lived event, that buyers and sellers will find workarounds through cutouts and friendly intermediary countries. That seems unduly optimistic.

First, decades of policies supporting globalization have sought to, and largely succeeded, in reducing “friction,” as in costs and hassle, for trading. Any workarounds will take time to develop, leaving trade partners stuck in the meantime. That stress on top of an energy price spike will lead to business failures. Even if not all that many, consider that cost on top of the additional issues.

Some of the discussions of workarounds also seem unrealistic. For instance, the US is now scrambling to find substitutes for Russian crude and is having to make nice to Venezuela. But experts contend that even if the US and Venezuela come to terms, Venezuela has had so many years of underinvestment, that it can’t supply all of the lost Russian capacity. And contrary to “energy independence” minded Republicans, the US can’t produce the heavy grades needed to mix with the super light shale product to produce diesel and heating oil. What happens if the US starts having shortages?

Second, any workarounds will increase the costs and risks of trading, such as more intermediaries and longer transit times. Just in time operations in particular could find it hard to adapt. Many shop floors provide for only minimal space for inventories as a JIT compliance enforcer.

Third, since the diversions will presumably go through countries that are maintaining relations with Russia. They are pretty certain to have first dibs.

Fourth, some goods, particularly food, aren’t amenable to “we’ll limp through with lower output for six months to a year and by then everything will hopefully be sorted.” Scarce and expensive essentials means hunger, stunted development, and more deaths. Readers have pointed out that Russia is an important supplier of fertilizer when global shortage is already underway. Russia and Ukraine are big wheat exporters.

Some commentators contend that Russia has famine in its future due to its dependence on imported seeds. It would take a more granular analysis to reach that conclusion. Yes, Russian production will suffer. But it is going to prioritize feeding its citizens first. So the first casualties of any seed-driven production shortfalls will be Russia’s agricultural goods buyers. This section of a tweet gives an idea of the caliber of what passed for analysis:

Russia Sanctions Trade Shock: Fulfilling the Fears of Smoot-Hawley? 2

Um, seed potatoes are not grown in Russia from seeds. “Seed potatoes” are confusingly potatoes grown from the root structure of other potatoes. And Russia imports about 90% of its potatoes, actual potatoes, and in 2019, about 85% of that was from Europe.

And Russia was already suffering from potato supply shortfalls and high prices because…..drumroll…it had already decided it couldn’t afford to rely on Europe. In 2021 has been buying from other sources like Belarus, Kazakhstan, Iran, Pakistan, and Egypt, which all were experiencing lower output levels. EastFruit explained that Russia had an “acute shortage” of potatoes as of early December 2021, as in before the war. So don’t let anyone attribute pricey potatoes to the war; it was a pre-existing condition. From EastFruit:

After Russian market participants began to realize in August that the country would experience a shortage of potatoes in the 2020/21 season, they immediately began to look for countries where potatoes are in abundance. Potato prices during this period broke away from the standard indicators and began to rise sharply. They are on 3 times average higher now than usually in this period, as can be seen in this EastFruit price monitoring chart.

Russia Sanctions Trade Shock: Fulfilling the Fears of Smoot-Hawley? 3

Russian supermarket chains are now starting to place orders for the supply of potatoes from Egypt. According to Egyptian potato exporters, chains are now asking for a record volume – up to 50 thousand tonnes to each! However, there are not enough potatoes in Egypt to cover this demand. The second problem is the price of Egyptian potatoes – taking into account delivery, prices reach $600 per tonne on the CIF Novorossiysk basis, excluding port fees and duties. And this is 50% times more expensive than the current price for potatoes on the domestic market of Russia which is already record!…

Thus, given the poor choice of suppliers, potato prices in Russia will most likely tend to increase from today’s 30 RUB/kg ($0.41/kg) to 50 RUB/kg in February 2022 or even higher. Given already record high prices for most of the traditional vegetables of the so-called “borsch set” and especially cabbage, rising potato prices to such high levels could also create additional difficulties for low-income consumers. At the same time, high prices for potatoes may again attract new farmers to grow them, although the basic requirements for entering this business in Russia are constantly growing.

If we are talking about actual seed imports by Russia, sugar beet farmers are the most dependent on imported seeds, which account for 75% of the total in 2019 according to Seed World, in a story describing Russia’s new program to reduce purchases of foreign seeds, most of all from the US. Russia is a significant importer of sunflower seeds and the US is the biggest source.

But…Russia is the biggest exporter of sugar beets and beet sugar. It also has a 3.1 million ton sugar stockpile. So any decline in sugar beet seed buys is more likely to hit exports than Russian borscht.

And those sunflower seeds? Russia and Ukraine are major sunflower oil exporters, together providing 90% of India’s supply. Even before getting to procuring seeds, the immediate conflict is producing big spikes in sunflower oil prices. And that means more expensive munchies. From Time:

To keep Martin’s Snacks’ 80,000-square-foot south-central Pennsylvania factory humming throughout COVID-19, CEO Butch Potter has had to shell out 20% more for potatoes than he did pre-pandemic. His packaging film expenses have increased 35%. Box prices are up 30%. He’s also had to raise wages to retain and recruit talent.

None of his operating costs increases, however, are as extreme as the price hikes in cooking oils—mostly of the sunflower and cottonseed variety—that Potter requires to produce snacks such as Jalapeño Kettle Cook’d Chips and Slender Pop Sea Salted Popcorn. Cottonseed oil costs Potter $0.99 per pound right now, he says. Eighteen months ago, it was half that. Sunflower oil is now $1.28 per pound, versus the $0.60 it cost in September 2020…

The two countries [Ukraine and Russia] are key players in certain major global industries, like computer chips, sunflower oil, grains, petroleum, and wood…

Companies like Martin’s Snacks that rely on sunflower oil will be particularly vulnerable. Ukraine is the largest exporter of sunflower oil in the world, responsible for up to 46% of sunflower-seed and safflower oil production, according to the Observatory of Economic Complexity. The second largest producer is Russia, which exports about 23% of the world’s supply.

Curiously Time does not mention that Russia produces 40% of the world’s palladium, is the number two platinum exporter, or that Russia, Kazakhstan and Uzbekistan provide the US with roughly half the fuel for its nuclear reactors, which produce about 20% of US electricity. But DefenseOne confirmed our concerns (hat tip RobertC):

Ukraine banned the export of wheat and other vital food commodities on Wednesday, triggering global fears for the food security of millions of people this year. Now the Pentagon has been urged to study how the disrupted food supply driven by Russia’s invasion of Ukraine will impact security around the world….

Ukraine is responsible for about 6 percent of global calorie exports, said Joseph Glauber, a senior research fellow at the International Food Policy Research Institute, or IFPRI. But in Egypt, for example, half of its imported calories come from Ukraine and Russia combined. In Lebanon, Russia and Ukraine account for 34 percent of its imported calories.

“Because Ukraine is one of the world’s largest wheat suppliers, especially for the developing world, Russia’s actions could cause a spike in food prices and lead to even more desperate hunger in places like Libya, Yemen, and Lebanon,” Linda Thomas-Greenfield, the U.S. representative to the United Nations, said last month. “The tidal waves of suffering this war will cause are unthinkable.”

I’m confused. I thought we’d established that the US and Europe didn’t care much about lives in those countries…but apparently being able to attribute their loss to Russia makes them more valuable.

And then we have chips, as in the non-snack food kind. A Gizmodo story Lambert picked up for Links goes into more detail on the impact of neon shortage. Two now-not-producing plants in Ukraine provide roughly 50% of the world supply of type used for chips. Gizmodo details some of the implications: small fry get hit the worst, but even the big boys like Samsung have only two months or a bit more of inventory. And this piece only consider neon, not the other area where Russia is a key player: the sapphire substrate used in higher-end chips. The short version is there are no ready substitutes.

Although the complexity of this situation makes it impossible to make any forecasts, consider: a worst case scenario is much much worse than stagflation. Just wrap your mind around the consequences the merely the two outcomes described above: a fair bit of famine and supply shortfalls, even potentially problems with maintaining some critical infrastructure due to chip scarcity. Some of that productive capacity loss could become permanent due to business failures.

And let us remind you….so far we are discussing only what the West has done to itself. What happens if Russia goes full Smoot-Hawley and retaliates, or engages in the passive aggressive version, as in no formal pronunciations, just supplies go to friendlies and the West gets chocked down, not 100% but enough to feel like that.

The Democratic Party is in the process of executing a controlled flight into terrain. Too bad that we are along for the ride.

1 The Biden Administration did not consult the Fed, and that level of lack of sanity-testing suggests that the Administration also neglected to get input from other experts who might have identified second order effects of the sanctions that would increase the damage to domestic constituencies.

I am about 30 years behind the times on the state of play with letters of credit. However, back then, there was a famous case of a buyer being scammed by paying for a tanker subject to a documentary letter of credit (if the seller delivers all the required documents, the funds are released). They included a certification of the cargo using what amounted to a dip stick test to verify that the cargo was indeed oil.

The shipment was oil, to the depth of the dip stick and then a bit more.

Below that was heavier salad oil.

Now as I read between the lines, the current LOCs are simpler, allowing for 30 days after landing for the buyer to pay for the cargo. I assume they get to inspect it to their heart’s content.

2 Each nation has its own implementation by treaty. However, all members of the World Trade Organization agree to give most favored nation status to each other. Russia joined the WTO in 2012.

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