Wednesday, January 04, 2006

Russian roulette? Try Russian facial surgery

As in, "Cutting off your nose to spite your face."

Most of you have probably heard of the drama between Russia and the Ukraine. For now we'll set aside Moscow's enmity (actually Putin's) for Ukrainian President Yushchenko, focusing only on the much higher prices that Russia wants to charge for natural gas: about $230 per 1000 cubic meters, versus the current $50. The Ukraine also wants 15% of the gas volume that flows through its pipelines, as a fee. The trade dispute is a very good illustration of basic price setting. There's no standard market price: prices are set subjectively, but the buyer must be willing and able to pay the price the seller demands.

It is of course desirable that both sides reach an agreement. Strangely enough, it is Russia that needs negotiations more, not the Ukraine. Russia tried to play hardball on Sunday by cutting off natural gas supplies to its European customers, but when Russia doesn't sell to the Ukraine and Europe, it's not earning as much money. Natural gas prices rose sharply, of course, but not enough that Russia earned the same revenue from its reduced sales. Similarly, my grocer could suddenly demand higher prices, but if I refuse and can hold out, the greater my purchases are of his business, the more he hurts himself by refusing to compromise. It's not very probable that the rest of his customers would pay so much that his income would not fall.

It may be too little, too late that Russia restored supplies and will try to boost them for the scarcity it caused. This BBC article notes that "some countries are advising firms to switch their energy demand." This is what happens when you anger your customers, who aren't as dependent on your supplies as you thought. Russia -- that is, the government and not the people, because oil and natural gas are all but completely nationalized -- might be earning a great deal of money without selling some of its natural gas to Ukrainians and some Europeans, but it had better take care not to estrange its customers.

Stephen Green has a very thoughtful analysis of the situation. I think, though, that Russia has a more immediate danger than death by demographic decline. Putin isn't just hindering the Russian economy: I think he will eventually destroy what could have been, should have been a vibrant economy that's recovering from the pains of post-communism transformation. Like Hugo Chavez is doing to Venezuela, Putin is preventing Russa from achieving its economic potential. For the time being, Russia can afford to hold out for higher natural gas prices, but that reduces its national income. Then when Russians cannot buy as much from their trading partners, their partners' income declines, and they will then be unable to buy as much (especially oil and natural gas) from Russians. This is the death cycle when trade is inhibited by government, whether by protectionism or by nationalist ego.

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