Some thoughts on Ukraine, part 2

Yesterday I looked at the Ukraine situation from a decision-tree framing. And my conclusion was that Western influence in Ukraine’s internal politics to aid regime change was a key factor in making the situation in Ukraine and its consequences more unpredictable. I believe markets are fairly complacent given the potential fallout, which could include military confrontation. Today, I want to use a different framing to look at Russian – US animosity over Ukraine. I am going to use the Franco-Prussian War as an analogy to give a sense of likely outcomes.

In the mid-1800s, Prussian leader Otto von Bismarck was embarking on a long-held German desire to unify the country. The smaller southern German states that were not a part of Prussia were in a precarious state because they were encircled by three huge countries, France, Prussia and the Austro-Hungarian Empire. Bismarck wanted to prevent those states from becoming part of the other empires. So he engineered a diplomatic crisis over the Spanish succession of Prince Leopold of Hohenzollern, the king of Prussia’s cousin.

Meanwhile, the French were already concerned about the Italian unification’s impact on French power, given the French occupation of Rome. A Hohenzollern in Spain was one move too far, as the French felt encircled. The result was that France declared war on Prussia and war began on 19 July 1870. The result was a fiasco for the French. France had no allies as the British felt the French were in the wrong. And so the French army proved no match for the military might of Prussia. Even Napoleon III was taken prisoner, with the main French army surrendering on 2 September at the Battle of Sedan. Prussian and German forces lay siege to Paris which was attacked mercilessly for four months.

With the French on the ropes, Bismarck declared the German Empire on 18 January 1871, allowing the king of Prussia to also take on the hereditary title as German emperor. With France government-less, Paris capitulated ten days later. When the Treaty of Frankfurt was signed ion 10 May 1871, a consolidated Germany transformed the landscape of Europe, instantly becoming the strongest state on the continent. France proceeded to erect a Third Republic, embittered by the humiliation suffered at the hands of the new German power to the east.

By the time we got to 1914 and World War I, this history was deep in french consciousness. When the Germans, Ottomans, and Austrians lost, France exacted revenge at the Treaty of Versailles, stripping Germany of its few colonies, deposing Kaiser Wilhelm, imposing French occupation, a demilitarized Rhineland, and harsh reparations that ended in German hyperinflation between 1921 and 1924.

What’s the lesson for history? Hostilities die hard.

The French never forgot the humiliation of the Franco-Prussian War and used World War I to repay the favour. In turn, Germany, a large geopolitically important economic and military power, faced an economic, political, and military winter of crushing proportions. However, given the size of the German population and the greatness of German industry, it was only a matter of time before the Germans came back to prominence. But they would do so now deeply embittered and ready for war – as many have predicted.

Analogously, the United States and Russia harboured strong feelings of antagonism that boiled over into the Cold War after World War 2 ended due to ideology. When the Soviet Union fell apart in the early 1990s, it was a bit of a land grab. Within Russia, political chaos ended with Boris Yeltsin consolidating presidential power with a new Constitution. But Russia lay prostrate economically, defaulting on its sovereign obligations in 1998. And Yeltsin’s legacy is dubious given the looting of state assets by oligarchs amongst other governance lapses. Outside of Russia, the US, NATO and the EU used Russia’s weakness as an opportunity to consolidate power in eastern Europe, taking NATO and the EU right up to Russia’s borders. Eventually Putin came to power, the grip of the oligarchs weakened, and the rise in oil prices helped Russia regain economic strength.

If I could overlay the Franco – German tensions onto the US – Russian ones, I would put 1918 in the French – German context as analogous to 1991 in the US – Russian one. From a Russian perspective then, 1991 was a catastrophe. The outcome was nowhere near as severely negative as it was for the Germans in 1918. But by 1998, Russia had lost vast amounts of land via newly formed post-Soviet states, it had lost “colonies” in eastern Europe, instead of hyperinflation, it faced sovereign default and birth rates plunged with the crash in the economy. You are not going to have good economic growth under those circumstances. Russia’s population hit a historic peak in 1991, with the population declining for 18 years straight until 2009. Wikipedia notes:

Key reasons for the slow current population growth are improving health care, changing fertility patterns among younger women, falling emigration and steady influx of immigrants from the ex-USSR countries. In 2012, Russia’s population increased by 292,400 people.

So Russia is back. And its leaders would have to feel a kind of bitterness toward the Americans similar to what the Germans felt toward the French. This is why people are making the Hitler – Putin connection. This is why people are reminded of the Sudetenland rhetoric and annexation and of the later Austrian Anschluss. This is why people are afraid of the potential for nationalist and expansionist ideology guiding Putin’s foreign policy. And so, it may be an outlier scenario but it is not inconceivable that we will see Russia re-assert itself in ethnic Russian areas outside of Russia in an analogous way to how Germany tried to annex ethic German regions outside of Germany.

Looking back at the history, I am trying to write it with a view toward understanding outcomes rather than judging motives. So excuse me for glossing over the history. I feel that looking at a situation without judgment and making comparison to history can yield a better understanding of decision-tree outcomes. So that is what I have done here.

My view is that, irrespective of the precipitating circumstances, any moves by Russia to annex new territory or to even recognize secession in Ukraine, Moldova or elsewhere will be met with economically punitive sanctions because it will be seen as a coup, bloodless or not. And to the degree Ukraine or Moldova react militarily, we should expect a reaction from Russia and an economic reaction from the EU, NATO and the US.

The situation in Ukraine has spiralled out of control. Just as in other areas where we have seen regime change in the last ten years like Iraq, Afghanistan, and Egypt, regime change has led to an unpredictable set of events. Regime change has destabilized Ukraine and because of Ukraine’s position outside NATO and neighbouring Russia, there is no opportunity for foreign powers to go into the country to stabilize the situation without an aggressive economic or military reaction elsewhere.

De-escalation at this point is going to be very tricky. The probability of an exogenous global economic shock from Ukraine is not an outlier as a result. What impacts the crisis in Ukraine will have are still unknown.

I have one more on Ukraine to come.