Ukraine

Is Vladimir Putin Acting Rationally?

Photo of Russian President Vladimir Putin from the *Wall Street Journal*.

On February 24, when Russian President Vladimir Putin launched an assault on Ukraine he apparently expected within a few days to achieve his main objectives, including occupying the Ukrainian capital of Kyiv and replacing the Ukrainian government. After three weeks, the fierce resistance of the Ukrainian armed forces have resulted in his failing to achieve these objectives. Although the Russian military had expected to experience few casualties or losses of equipment, in fact Russia has already lost more military personnel killed than the United States has since 2001 in Afghanistan and Iraq combined, as well as experiencing the destruction of many tanks, planes, and other equipment.

The United States, the European Union, and other countries have imposed economic sanctions on Russia that have reduced the country’s ability to import or export most goods, other than oil and natural gas. The sanctions have the potential to reduce the standard of living of the average Russian citizen.

Most importantly, the war has killed thousands of Ukrainians and inflicted horrendous damage on many Ukrainian cities.

Despite all this, is Putin’s persistence in the invasion rational or if he were acting rationally would he instead withdraw his troops or accept a political comprise (at this writing, negotiations between representatives of Russia and Ukraine are continuing)? First, recall the economic definition of rationality: People are rational when they take actions that are appropriate to achieve their goals given the information available to them. (We discuss rationality in Microeconomics, Chapter 10, Section 10.4, and in Economics, Chapter 10, Section 10.4.) Note that rationality does not deal with whether a person’s goals are good or bad. In this discussion, we are considering whether Putin is acting rationally in attempting to achieve the—immoral—goal of subjugating a foreign country.

Peter Coy, a columnist for the New York Times, discusses three reasons Putin may continue his attack on Ukraine even though, “The bloody invasion of Ukraine has been a disaster” for Putin. The first reason, Coy recognizes, involves an economic concept. His other two reasons can also be understood within the economic framework we employ in Microeconomics.

First, Coy argues that Putin may have fallen into one of the pitfalls to decision making we discuss in Chapter 10: A failure to ignore sunk costs. Coy notes that Putin may want to continue the attack to justify the death and destruction that has already occurred. However, those costs are sunk because no subsequent action Putin takes can reduce them. If Putin is continuing the attack for this reason, then Coy is correct that Putin is not acting rationally because he is failing to ignore sunk costs in making his decision.

There is a subtle point, though, that Coy may be overlooking: Putin is effectively a dictator, but he may still believe he needs to avoid Russian public opinion turning too sharply against him. In that case, even if recognizes that he should ignore sunk costs he may believe that the Russian public may not be willing to ignore the costs of the death and destruction that has already occurred. In that case, his refusal to ignore this sunk cost be rational.

Coy’s second reason why Putin may continue the attack is that he may believe “just another few weeks of fighting will be enough to subdue Ukraine.” Although Coy doesn’t discuss the point in these terms, it would be rational for Putin to continue the attack if he believes that the marginal benefit of doing so exceeds the marginal cost. (We discuss this point directly in Chapter 1, Section 1.1 “Optimal Decisions Are Made at the Margin,” and provided many examples throughout the text.) The marginal cost includes the additional Russian military casualties and losses of equipment from prolonging the war and the cost of economic sanctions to the Russian economy. (It seems unlikely that Putin is taking into account the additional loss of life among Ukrainians and the additional devastation to Ukrainian cities from prolonging the war.)

The marginal benefit from continuing the attack would be either winning the war or obtaining a more favorable peace settlement in negotiations with the Ukrainian government. If Putin believes that the marginal benefit is greater than the marginal cost, he is acting rationally in continuing to attack.

Coy’s final reason why Putin may continue the attack is that “he has little to lose by fighting on.” Although Coy doesn’t discuss the point in these terms, Russia may be suffering from a principal-agent problem. As we discuss in Microeconomics, Chapter 8, Section 8.1 (also Economics, Chapter 8, Section 8.1 and Macroeconomics, Chapter 6, Section 6.1) the principal-agent problem arises when an agent pursues the agent’s interst rather than the interests of the principal in whose behalf the agent is supposed to act. In this case, Putin is the agent and the Russian people are the principal. Putin’s own interest may be in prolonging the war indefinitely in the hopes of ultimately winning, despite the additional Russian soldiers who will be wounded or killed and despite the economic suffering of the Russian people resulting from the sanctions.

Although as president of Russia, Putin should be acting in the best interests of the Russian people, as a dictator, he can largely disregard their interests. Unlike his soldiers, Putin isn’t exposed to the personal dangers of being in battle. And unlike the average Russian, Putin will not suffer a decline in his standard of living because of economic sanctions.

Appalling as the consequences will be, Putin’s continuing his attack on Ukraine may be rational.

Sources: Peter Coy, “Here Are Three Reasons Putin Might Fight On,” New York Times, March 14, 2022; Alan Cullison, “Talks to End Ukraine War Pause as Russia’s Offensive Intensifies,” Wall Street Journal, March 14, 2022; and Thomas Grove, “Russia’s Military Chief Promised Quick Victory in Ukraine, but Now Faces a Potential Quagmire,” Wall Street Journal, March 6, 2022.

Will the U.S. Ban on Russian Oil Imports Reduce Russian Oil Revenue?

Photo of Russian oil refinery from the *New York Times*.

On March 8, 2022, President Joe Biden announced that the United States would no longer allow new shipments of oil from Russia to the United States. Russian oil made up about 8 percent of total U.S. oil imports and about 2 percent of U.S. oil consumption. European countries, which are much more heavily dependent on oil imports from Russia, announced plans to gradually reduce Russian oil imports.

The point of these policy actions was to reduce the revenues Russia would receive from oil exports as retaliation for Russia’s invasion of Ukraine. Beyond the effect of direct action against Russian oil imports, Russian oil exports were reduced further as a result of other sanctions imposed on the Russian economy by the United States and other countries. These sanctions made it difficult for Russia to access shipping services and the international payments system.

The decline in Russian oil exports reduced the total supply of oil on the international oil market, pushing up the price of the oil. The following figure shows the daily price in dollars per barrel of Brent crude oil, which is the most commonly used benchmark price of oil.

Will the actions taken by the United States and other countries reduce Russian oil revenues? As we discuss in Microeconomics, Chapter 6, Section 6.3, whether a seller’s total revenue will decrease as a result of a decrease in the quantity sold depends on the price elasticity of demand for the seller’s product. If demand is price elastic, the revenue the seller receives will fall. If demand is price inelastic, the revenue the seller receives will rise.

In this case, Russia’s oil revenue will decline if the percentage increase in the price of oil is less than the percentage decrease in the quantity of oil Russia is selling. The energy information firm Energy Intelligence has estimated that Russian oil exports have declined by about one-third. On the day before the Russian invasion of Ukraine, the price of Brent crude oil was about $99 per barrel. It then rose to $129 per barrel on March 7 before falling to $109 per barrel on March 10. Based on these values, the price Russia received per barrel of oil increased between 9 and 29 percent or by less than the 33 percent decline in the quantity of oil Russia sold.

Because the percentage decline in quantity was greater than the percentage increase in price, we can conclude that the actions taken by the United States and other countries reduced Russian oil revenue. In fact, the reduction in revenue is probably larger than indicated by the change in the price of Brent crude oil. Media reports indicate that to find buyers Russia is having to discount its oil by more than $10 per barrel from the Brent price. In addition, the countries of the European Union have pledged to reduce Russian oil imports by two-thirds by the end of 2022 and the United Kingdom has pledged to end them entirely. Although Russia might be able to redirect to other countries some oil it had been exporting to Europe and the United States, it seems likely that Russia’s total oil exports will eventually decline by more than the initial one-third.

Sources: Andrew Restuccia and Josh Mitchell, “Biden Bans Imports of Russian Oil, Natural Gas, Wall Street Journal, March 8, 2022; Stanley Reed, “The Future Turns Dark for Russia’s Oil Industry,” New York Times, March 8, 2022; Collin Eaton, “How Much Oil Does the U.S. Import From Russia and Why Is Biden Banning It?” Wall Street Journal, March 9, 2022; “Russian Oil Exports Fall by One-Third,” energyintel.com, March 2, 2022; and Tsuyoshi Inajima and Serene Cheong, “More Russian Oil Deeply Discounted as Ban Risk Alarms Buyers,” bloomberg.com, March 7, 2022. Brent crude oil price data from the Federal Reserve Bank of St. Louis and the Wall Street Journal.

Glenn’s Opinion Column on the Economics of an Increase in Defense Spending

Glenn published the following opinion column in the Wall Street Journal. Link here and full text below.

NATO Needs More Guns and Less Butter

Russia’s unprovoked invasion of Ukraine has challenged Western assumptions about security, economics and the postwar world order. In Europe and the U.S., public finances have long favored social spending over public goods such as defense. While President Biden doubled down on his proposal to increase social spending during his State of the Union address, Russia’s aggression highlights the shortcomings of this model. Western democracies now face a more uncertain and dangerous world than they did two weeks ago. Navigating it will require significantly higher levels of defense and security spending.

But change will be difficult, and the magnitude of what needs to be done is sobering. The U.S. currently spends 3.2% of gross domestic product on defense—roughly half of Cold War spending levels relative to GDP. An increase in spending of even 1% of GDP would amount to about $210 billion. That’s about 5% of the total federal spending level using a 2019 pre-Covid baseline. While Covid spending was large, it was transitory. Defense outlays would be much longer-lasting, an insurance premium or transaction cost for dealing with a more dangerous world.

The U.S. is not alone. Germany’s announcement of €100 billion in additional defense spending this year represents an increase of just over 0.25% of GDP, leaving Berlin still under the 2% commitment agreed to by North Atlantic Treaty Organization allies. Increasing Europe’s defense spending merely to the agreed-on level would require significant outlays. Such spending increases would occur against the backdrop of elevated public debt relative to GDP, brought on in part by heightened borrowing during the Covid pandemic and the earlier global financial crisis. High levels of public debt make it unlikely that countries will want to pay to increase their defense spending with new borrowing.

Paying for higher levels of defense spending will force most governments either to raise taxes or cut spending. Tax increases raise risks to growth. The larger non-U.S. NATO economies are already taxed to the hilt. Tax revenue relative to the size of the economy in France (45%), Germany (38%), Canada (34%) and the U.K. (32%) doesn’t leave much room to tax more without depressing economic activity. The U.S. has a lower tax share of GDP—about 17.5% at the federal level and 25.5% in total—but its patchwork quilt of income and payroll taxes makes tax increases more costly by distorting household and business decisions about consumption and investment.

A significant tax increase in the U.S. would need to be accompanied by fundamental tax reform, dialing back income taxes (as with the 2017 reduction in corporate tax rates) and increasing reliance on consumption taxes. A broad-based consumption tax could be implemented by imposing a tax at the business level on revenue minus purchases from other firms (a “subtraction method” value-added tax). Alternatively, the tax system could impose a broad-based wage and business cash-flow tax, with a progressive wage surtax on high earners. These consumption-tax alternatives would be efficient and equitable in a revenue-neutral tax reform. And they are crucial in avoiding decreases in savings, investment and entrepreneurship that accompany a tax increase.

Since the 1960s, spending on Social Security, Medicare and Medicaid has come to dominate the federal budget. Outlays for these programs have almost doubled since then as a share of GDP to 10.2% today, and the Congressional Budget Office projects they will consume about another 5% of GDP annually by 2040. Spending offsets to accommodate higher defense spending would surely require slowing the growth in social-insurance spending. As with tax increases, there are trade-offs. It is possible to slow the growth of this spending while preserving access to such support for lower-income Americans. Accomplishing that will require focusing net taxpayer subsidies on lower-income Americans, along with undertaking market-oriented health reforms. Such changes require serious attention.

The U.S. and its NATO allies will face a challenging set of economic trade-offs and political realities in achieving higher defense spending. The challenge will be exacerbated by additional private investment needs in a more dangerous world of investment risks, skepticism about globalization, and cybersecurity threats.

In the U.S., the failure of the 2010 Simpson-Bowles Commission’s proposed spending and tax reforms to spark a serious discussion is a warning sign. So, too, is the antipathy of Democratic and Republican officials alike toward creating the fiscal space necessary to accommodate greater defense spending. Such challenges don’t cause threats to vanish. They require leadership—now.

3/01/22 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss Russia’s Invasion of Ukraine.

Authors Glenn Hubbard & Tony O’Brien reflect on the global economic effects of Russia’s invasion of Ukraine last week. They consider the impact on the global commodity market, US monetary policy, and the impact on the financial markets in the US. Impact touches Introductory Economics, Money & Banking, International Economics, and Intermediate Macroeconomics as the effects of Russia’s aggression moves into its second week.

A map of Europe with Ukraine in the middle right below Belarus and to the east of Poland.

On Tuesday, March 1, Glenn and Tony will record a podcast on the economic consequences of the Russian invasion of Ukraine. The recording will be posted to this blog and also available through iTunes.

Some useful links

General information on developments (political and military, as well as economic):

Updates on the website of the Financial Times (note that the FT has dropped its paywall to allow non-subscribers to read this content). This article on the possible effects on the global economy is particularly worth reading.

The Twitter feed of Max Seddon, the FT’s Moscow bureau chief, is here.

The website of the New York Times has an extensive series of updates focused on military and political developments (subscription may be required).

Streaming updates on the website of the Wall Street Journal (subscription may be required).

A Twitter feed that provides timely updates on the military situation.

An article in the New Yorker discussing Russian President Vladimir Putin’s claims about the historical relationship between Russia and Ukraine.

A pessimistic blog post by a retired U.S. Army Colonel on whether the U.S. military is equipped to fight a war in Europe.

Discussions focused on economics:

As background, the following figure from the Our World in Data site shows the growth in real GDP per capita for several countries. The underlying data were compiled by the World Bank and are measured in constant international dollars, which means that they are corrected for inflation and for variations across countries in the purchasing power of the domestic currency.

In 2020, Russian GDP per capita was less than half that of U.S. GDP per capita although about 50 percent greater than GDP per capita in China. GDP per capita in Lithuania, part of the Soviet Union until 1991, and Poland, part of the Soviet bloc until 1989, are significantly higher than in Russia. These two countries have become integrated into the European economy and have grown more rapidly than has Russia, which continues to rely heavy on exports of oil, natural gas, and other commodities. Ukraine is not as well integrated into the European economy as are Poland and Lithuania and Ukraine experienced little economic growth since attaining independence in 1991. In fact, Ukraine’s real GDP per capita was lower in 2020 than it had been in 1991.

Here is a transcript of President Joe Biden’s speech imposing sanctions on Russia.

Informative Full Stack Economics blog post by Alan Cole explaining the likely reasons why U.S. and European sanctions on Russia excluded energy. Useful explanation of the role of correspondent banking in international trade.

An article in the Economist discussing sanctions (subscription may be required).

An article in the New York Times discussing the SWIFT (Society for Worldwide Interbank Financial Telecommunications) service, which is based in Belgium, and is a key component of the international financial system. Some policymakers have proposed cutting Russia off from SWIFT. The article discusses why some countries have been opposed to taking that step (subscription may be required).

An opinion column by Justin Fox on bloomberg.com examines in what sense the United States is energy independent and the economic reasons that the U.S. still imports some oil from Russia (subscription may be required).

Blog post by economic writer Noah Smith on the possible effects of the invasion on the post-World War II international economic system.