There's no doubt that the impact of the former financial crisis on the global economy was grossly underestimated even in its early stages. The reason is that today's global economy is extremely intricate - a massive matrix of interwoven relationships impossible to even partially comprehend. In economics we try our best to focus on small models that we hope can be used to understand the bigger forces at play, with admittedly limited success.
One critical by-product of the former financial crisis was damage done to global trade. Many of you may also have watched as financially solid (good cash flow, manageable debt) businesses were strangled simply by their inability to get letters of credit. After all, banks and other lenders had no idea whether they were in fact solvent, so when liquidity froze, so did trade.
Trade has become the lifeblood of the global economy. Business professors are quick to compare the stagnating isolated economy of North Korea versus the South Korean powerhouse fueled by international trade.
It is surprising that investors and forecasters alike seem oblivious to the potential harm that the sanctions already implemented will have on Russia and its trading partners.
One of the most fundamental lessons for young economics students is that trade between two countries makes both better off. The proof is usually derived arithmetically then illustrated graphically. It is possible with trade to expand total domestic production beyond one economy's production possibilities frontier by introducing trade. Produce more of the good you have a comparative advantage producing, and trade with a country that has an advantage in some other good. The star in the diagram represents a point outside the productions possibility frontier.
For example, Russia supplies raw materials (minerals, oil and gas) to many European trading partners, and they supply food products. Everyone is better off because of trade.
Economists also agree that there is a multiplier effect - incomes in general improve, which of course boosts consumption and savings and so forth. Buoyant global growth in recent decades no doubt has been due to the multilateral and bilateral free or relaxed trade agreements that continue to be negotiated.
But turn the tables around and what will happen? Trade hostilities must also have a multiplier effect - but in reverse.
Russian export growth got off to a slow start this year even before the tougher second round of sanctions were introduced. Since exports account for 20.6% (WTEX) of total Russian economic output ($526.4 billion), things can get very ugly. Of these exports, I estimate $276.4 billion (converting from euros at 2013 rates) went to the European Union. Assuming a Keynesian foreign trade multiplier for Russia of something in the neighborhood of 1.5X*, then a reduction in exports of 15% this year due to sanctions could knock at least a half a percent off of Russian GDP. In my opinion, the Keynesian macro approach hugely underestimates the negative multiplier effect that a more in-depth microeconomic analysis would imply.
Piecemeal articles are beginning to grasp some of the potential damage to Russia:
From Forbes: According to a report from IHS Automotive, car sales in Russia were already falling in the first half year as the economy creaked, consumer confidence declined and the falling value of the rouble increased prices of imports and components. Car sales fell 7.6 per cent in the first half of the year, including a dive of 17.3 per cent in June. This raised concerns that car sales will fall sharply in the second half of the year, the report said.
The more difficult measure to contemplate is the impact of reduced imports from Russia on the European economy. Substitutes, if available in the short run at all, for the stuff Russia exports to Europe will suddenly be incredibly expensive. Imagine if the supply of energy in the U.S. (almost self-sufficient nowadays) from domestic production just wasn't available suddenly. Take away the coal, lumber and minerals produced domestically as well. It seems unlikely that trade sanctions will escalate into a full scale embargo but despite this, markets do not seem to be discounting nearly enough of the risk that should be factored in - especially in equity markets.
True, the US does not deal much with Russia directly.
These numbers are hardly big enough to seriously hurt the Goliath US economy. But if Europe hurts, and it certainly will, then everyone doing business with the EU will hurt some as well. The US in 2013 traded $650 billion with Europe. If trade makes countries better off, then stifling international trade makes them worse off.
What makes the current situation so perilous is that the stuff Europe imports (raw materials, especially fuel) is a critical low-value input into Europe's higher value-added exports. Copper wiring might not seem to be such a huge component of an automobile, but without the copper it's pretty hard to finish building the car. The outlay for the copper as a percent of the price of the vehicle might not seem large, but the revenue forgone by not being able to complete and sell the automobile sure is big enough.
Manufactured products comprise nearly 80% or the lion's share of the value of European exports - additional value (read higher production and income) that has been created from the fuels and mining products that have been imported. President Obama in the US and Stephen Harper in Canada are pressuring Europe into shouldering what will be a very heavy economic burden of punishing Russia for its unwanted aggression.
The strength in the bond markets could be signaling that a storm is brewing, but will it be a thunderstorm or a tornado? That is impossible to discern ahead of time, just as nobody had an inkling of just how much liquidity had to be pumped back into the global banking system to offset the negative multiplier effects ignited by that financial crisis - effects that continue to linger.
On the other hand, equity markets seem ill-prepared for the pending surprise. Private sector earnings will certainly be impacted on a global scale. Recall how investors underestimated the extent of the economic damage (again, trade-related) by the 2011 Tohoku earthquake. Although the quake and tsunami occurred in March, it wasn't until July that stocks suffered. The S&P 500 on July 18th was at 1345.02 and by August 15th had declined to 1123.53 (a 16.5% hit).
Earlier this year, the European Commission's published forecast for EU growth in 2014 was an optimistic 1.5%. Clearly expectations have since then been adjusted downward, but not nearly enough given the wrench just thrown into the machinery of international trade. If European economic 'growth' turns out to be a negative number, remember it was I that coined the phrase to describe Europe's next recession - since it will be caused by trade sanctions against Russia I'll name it the......"Russession."
*Studies have tried to empirically estimate the marginal propensity to consume and the marginal propensity to import for many countries. My own back-of-the-envelope FT multiplier assumes a Russian MPC of .53, tax rate of 20% and MPM of .21 yielding 1.587 but who in their right mind would take this number seriously?
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.