Ukraine, History and Investments

By Bob Peters || April 22, 2022

This blog post is longer than most but I had fun writing it.

I found my senior thesis and it reminded me how much I have grown
to appreciate the importance of studying history.

My interest in foreign policy and international affairs was sparked during my undergraduate college years while pursuing my BA in International Studies at the University of Washington.    In rummaging through one of my bookshelves I ran across my senior thesis and it reminded me how these past 39 years have reinforced my belief that studying history is very important.

The paper, “Should Current U.S. Law, Restricting Federal U.S. Commercial Lending Institutions to Lend up to 10% of Equity Capital to Centrally Planned Economies, be eliminated”, hand typed by yours truly with typos and misspellings long before computers and spell check.  I’ll spare you the titillating details and take you to my conclusion:  the US law mentioned above should be maintained for both national security interests and best interest of US Commercial Banks.  I asserted that the benefits of increased economic ties were insufficient to offset national security and banking sector risks if we increased our “exposure” to governments that did not share political values.

On the opening page before the Introduction, I used two quotes:

I’ll refer back to these quotes later as the current Ukraine crisis, unprecedented economic sanctions, and Europe’s reliance on Russian energy are to some extent reflective of the Western countries not heeding the words of Buchanan and Nixon.

The Iron Curtain

When I wrote the paper in May of 1983 the Cold War bifurcated the world into two superpower spheres of influence.  The US led sphere represented the post-World War 2 democracies with free market economies and the other led by the Russia along with countries that were under the umbrella of the Soviet Union (aka the “Eastern bloc”) such as Poland, East Germany, Romania, Hungary, Czechoslovakia, Lithuania, Estonia, Latvia, Georgia, Ukraine, etc.  The democratic, free market economies were referred to as the “West” and included Japan, South Korea, Denmark, Sweden, Norway, West Germany, United Kingdom, Australia, New Zealand, France, Netherlands, Spain, Portugal, Italy, Luxembourg, Belgium, etc.

There were very distinct differences between the West and the East in addition to the absence of voting rights, free media, political parties.  The Soviet Union operated as a police state restricting its citizens from leaving the country. The common reference at the time referred to the Eastern bloc as “behind the Iron Curtain.”

Looking over The Wall at Checkpoint Charlie

In 1984 I backpacked around Europe and visited Berlin which was separated into four zones controlled by the US, UK, France and Russia.  There was a physical wall built by Russia and East Germany that separated the three zones controlled by the US, UK and France from the Russian zone and remainder of East Germany.  The primary purpose of the wall was to keep East Berliners/Germans (part of the Eastern bloc) from escaping to West Berlin (part of the West). 

The crossing through this wall was heavily fortified and every person and car was checked.  I walked into East Berlin through the American checkpoint, Checkpoint Charlie. Before walking into East Berlin, I ascended a lookout platform that was used by Western “tourists” who did not want to enter East Berlin but were curious to get a look on the other side of the wall.  When I was standing on the platform and able to look over the wall, I was staring into the window of what looked like a World War 2 era office building.  The side of the building was probably 15 yards away. I noticed a man who seemed to be nonchalantly working at a desk.  It was surreal; like going to the zoo and staring at the animals behind bars.  Very eerie indeed.  Everyone on the West side of the wall could travel as they pleased and everyone one the East side of the wall were essentially prisoners of their government.

Centrally Planned Economies

One additional difference between the West and the Eastern bloc was free market capitalism that allowed private business ownership (West) vs. government owned businesses controlled by the State (Eastern bloc).  The Eastern bloc economies were referred to as Centrally Planned Economies whereby the government bureaucrats controlled effectively 100% of the ownership of all business activity.  Unlike where Western businesses operated under the concept of free market capitalism (supply and demand), Centrally Planned Economies operated under a government 5-year plan.  For example, if the 5-year plan required 100,000 automobiles to be produced each year, the government owned plants would be expected to produce 100,000 cars each year, regardless if that fell short, met or exceeded actual demand for cars.

The problem with Centrally Planned Economies was a misallocation of capital.  Investments were made by the government not based on the merits of the investments.  Over a long period of time, such an economy becomes less and less competitive.  In a free market economy with non-government ownership of businesses, capital gets allocated to the areas that have the best risk-reward potential and, as a result, the economy is much more adept to meet the changing needs of consumers.

What about China?

When I wrote the paper in 1983, it was a little over 4 years after President Carter recognized the People Republic of China and severed the ties with Taiwan.  The US Congress was not happy with this action and passed the Taiwan Relations Act which gave Taiwan nearly the same status as any other nation recognized by the United States including the commitment to sell military arms and provide a security guarantee to protect Taiwan if it were attacked.  In 1983, China was an emerging country with little economic or military might.  Many folks in the West saw the huge population of China and its growing wealth as a potential new market to sell goods and services.  China offered low-cost labor to produce goods to be sold into the Western markets at much lower costs.  What’s not to like about this?  The West gets cheaper goods and a new market to sell goods and services.

The West pursued its’ economic interests first believing that by doing so would increase the average Chinese standard of living and the political system of government would come to embrace the democratic values of the West.  The West was wrong.

China and Russia…two different paths for two autocratic governments

Russia and China were both Communist governments.  They both disallowed competing political parties, but their embrace of capitalism had a different approach.  Prior to the 1991 break up of the Soviet Union, essentially all Russian businesses were government owned.  After the breakup of the Soviet Union many of the senior government officials essentially “took over” government assets and these individuals became ultra-wealthy.  It was a wild west of sorts with rampant assassinations as government assets were put into the hands of individuals who were supportive of the government.  Corruption became pervasive where government contracts were inflated and awarded to a small number of very wealthy individuals.  Another very defining difference between the Soviet Union/Russia and China were disparities in natural resources.  Russia had tremendous resources in oil, natural gas and metals.  China did not.

Cheap Labor and Big Market

In 1978, thirteen years prior to the dissolution of the Soviet Union, the Chinese Communist Party (CCP) allowed for the private formation of businesses.  While there remained substantial state-owned businesses, the CCP encouraged private foreign capital to flow into the country.  The CCP encouraged foreign investment, namely from Western businesses who saw 1) cheap labor with which to improve profitability and 2) a huge untapped Chinese domestic market for their products.  What’s not to like about this?

The Rule of Law, Technology Transfer and Corruption

Two things stand out.  First, China has no rule of law.  The CCP had complete authority to take any action and change “the rules” at any time.  If you have a contract dispute in the West, there is a rule of law that all parties understand.  Disputes are settled in court based on laws that, by and large, are predictable.  In China laws protecting the rights of parties involved were scant and subject to the CCP changing them in unpredictable ways.

The second was a requirement that foreign investors needed to have a Chinese company own 50% of any foreign joint venture.  The CCP also required that all Chinese companies were to make available all information, including proprietary company secrets (aka intellectual property) owned by businesses in China at the request of the government with no restrictions (referred to as technology transfer).

Western businesses judged that the benefits of cheaper labor and huge untapped markets were worth the absence of predictable laws and the loss of proprietary secrets.  Over 40 years Chinese businesses, with support of the CCP, gained knowledge to compete against Western companies and now China is a few years away from becoming the largest economy in the world.  A number of Chinese companies are world class competitors, and they have the CCP in support of making sure that they have a competitive advantage against foreign firms.

China and Russia were subject to a lot of corruption early in their “opening” but, unlike China which embraced private ownership, the Russian government relied on a corrupt relationship between the wealthy owners of businesses to function (Crony Capitalism).  Corruption remains an issue in both countries but is being addressed more effectively in China and will likely remain unaddressed in Russia for the foreseeable future.

China and Russia…Autocracies both

Both China and Russia are Autocracies where one person has complete control.  In the case of China, membership in the Communist Party is a requirement to hold a government office.  The ability of any government employee to move into higher positions in the government is based on the favor of those at the top of the CCP.  The citizens of China do not vote for their government.  The CCP is the sole political Chinese party and they do not allow for meaningful dissent to occur (no free speech).

In contrast, after the fall of the Soviet Union, Russia formed institutions that mimicked those of Western democracies with judicial and legislative branches of government.  There were multiple political parties, the citizens were given the right to vote and in there was some limited degree of free speech.  Over the last 22 years, since Vladimir Putin became President, democratic institutions have transformed into self-serving shells that keep Putin in power.  Political parties were banned, opposition leaders were imprisoned or killed, free press was eliminated, and elections were rigged.  The slow but steady erosion of democratic values was persistent.  Income inequality widened as politically connected oligarchs harvested economic gains.  An apt metaphor is the frog that boils to death in a pot of water that is slowly heated up.  The citizens of Russia lived in the pot and were unable to turn down the heat.

The Peace Dividend and how the Pie got bigger

After the collapse of the Soviet Union, Western governments could reallocate their financial resources away from military spending into more productive parts of their societies.  This was referred to as the Peace Dividend.  Many countries formally under the control of Russia in the Soviet era became democratic which attracted foreign investment.  The wealth of the citizens of these countries grew.  During the same period Western countries benefited from the economic growth in China.  For three decades the pie got bigger and there was increased prosperity albeit plenty of inequality.

European leaders desire to forge economic ties with Russia

With the collapse of the Soviet Union, Western European leaders were eager to forge economic ties with Russia.  After all, the Iron Curtain had dropped and there was optimism about the future.  Gas and Oil pipelines were built to bring needed energy from Russia to Western Europe.  While the US had concerns about Western Europe becoming economically dependent on Russian energy, governments in Western Europe pursued Russian energy supply agreements.  These European Western governments, although uncertain about the political reliability of the Russian nascent democratic system, believed that the economic benefit of trade outweighed the risk of giving Russia a hammer.  In my senior thesis, I referenced a 1982 paper, Soviet Gas Pipeline:  US Options, authored by John Hardt, Senior Specialist and Donna L. Gold, Office of Senior Specialist.  The collapse of the Soviet Union happened 9 years after this paper was written but the lesson is relevant to this day.  If you can’t trust the political system of your trading partners no amount of economic benefit of increased trade will compensate for the downstream political risk.

Russia and China…no prohibited areas of cooperation

As the 2022 Beijing Winter Olympics was kicking off on Feb 4, 2022 the Russian President, Vladimir Putin met with Chinese President, Xi Jinping met and announced that their relationship surpasses an alliance and that there were no prohibited areas of cooperation.  The link to the actual Sino-Russian press release reads like both countries are democratic.  Actions speak louder than words…they are not.  Twenty days after this joint statement, Russia invaded a sovereign Ukraine. Eight weeks later numerous war crimes have been documented by Russian troops and 6 million Ukrainians have been displaced from their homes.  There is no end in sight for the war and the suffering of millions of innocent citizens of Ukraine.  Ever since the war started, China has not condemned Russia and blames the West.  On March 2, 141 countries in the UN condemned Russia and 4 countries supported Russia, including China.

Energy dependence by Western Europe funnels more money to Russia

When the Russian invasion of Ukraine broke out on February 24^th, 2022 many of the Western democratic countries imposed severe economic sanctions on Russia in an attempt to economically penalize Russia.  The hope is that these sanctions will bring about the end of Russia’s aggression against Ukraine but there is one big hole:  Germany’s dependence on Russian energy which takes me back to my senior thesis.  The German policy of building energy ties with Russia going back to the 1980’s all of a sudden backfired.  Approximately 50% of Germany’s natural gas and 30% of oil is supplied by Russia.  Germany is Europe’s largest economy and their reliance on Russian energy is so great that they can’t shut it off without severely crippling their economy.

Energy dependence by Western Europe funnels more money to Russia.  Since the Russian invasion, approximately $30 billion/month has been paid by European governments to Russia and it will take many months to wean themselves off of this source of energy.  In the meantime, Russia gets money to fight an immoral war against Ukraine.

The two quotes I used in my thesis and listed at the beginning of this blog are relevant today.

It’s hard to be friendly with governments who depend on having an enemy to justify their power.  It’s also naïve to believe that autocratic governments will change to true democratic principles if given economic prosperity.

The Pie Shrinks

The Russian-China alliance, which is supported, in part, by the “neutrality” of other autocratic, resource rich countries is dividing the world into two spheres.  The Peace Dividend of the last 30 years is coming to an end.  Governments act based on their “interests.”  Sometimes, they align on values, but not always.  With many of the world governments moving as quickly as they can towards clean sources of energy, the clock is ticking on those that have prospered and relied on their rich energy natural resources.  The China-Russia partnership and the interests of the oil rich countries that are interested in maximizing their earnings from the sale of energy resources will likely be in one sphere.  The preponderance of true democratic countries will be in a separate sphere.  The democracies (both governments and private companies) have had a punch in the nose.  Russia’s aggressive actions using energy as a weapon and being militarily hostile towards sovereign countries will lead to a shrinking of world trade.  When trade shrinks, the pie shrinks too. 

Investing Wisely…what do We Know

Nobody can predict the future including the price of stocks.

We know that as the yield on the risk-free rate (US Treasury securities) increases the price of other “risk” assets like stocks go down.  We know that as the Federal Reserve tightens monetary policy, there is less air in the balloon and asset prices (including stocks) go down.  We know that inflation is a tax on wealth and the Federal Reserve will fight this by increasing short term interest rates.  We know that increasing short term interest rates reduces consumer demand for products and services.  We know that companies sell fewer products and services when consumer demand softens.  We know that companies cash flow declines when they sell fewer products and services.  We know that cash flow decreases for businesses that borrow money when interest rates increase. We know, all things being equal, the value of a business declines as future expected cash flows decline.  We know that if world trade contracts because of geopolitical realities, the amount of wealth decreases.

Nobody can predict the future.  We also know that market timing is a fool’s errand and staying invested through all markets is better than trying to guess when to buy and sell.  We also know that past stock market returns have been above average and that future expected returns are likely to be lower over the next decade.  All of that said, there are macro events in the world that are good to understand.  You can invest wisely, be curious, and use your critical thinking to evaluate the world we live in.

I am very grateful to live in the United States

Lastly, I am very grateful to live in the United States.  Our country was founded by immigrants who were frequently persecuted in their home countries.  The United States was the first country to adopt a true democracy and a constitution that provides protections of its citizens.  The authors of the Constitution were imperfect men as evidenced by their legacy of slavery and lack of equal rights of women.  All true, but they were also gifted in the drafting of the Constitution and the Bill of Rights.  Our elected officials have made mistakes, but our free press and judicial system are there to call attention to malfeasance.  There is no person above the law.  I have no interest in relocating to China or Russia.

The problem with governments with ultimate power is best characterized by the words of Lord Acton, “Absolute power corrupts absolutely.”