Speculations on the Macroeconomic Consequences of a Nuclear Attack on Moscow

Speculations on the

Macroeconomic Consequences

of a Nuclear Attack on Moscow

Haas School of Business

University of California, Berkeley

March 30, 2005

These notes are in response to a scenario planning exercise “The Big Bang.”¹ This set of scenarios first addresses the immediate, short, and longer-term effects of a Moscow catastrophe on the Russian economy. The major uncertainty here is how the political system reacts to the disaster.
I then turn to a more speculative analysis of the effects on the global economy. The major uncertainty here is whether investors perceive high likelihood of (or experience) a nuclear attack on the West.

What happens to the Russian economy?

Immediate reaction (1 day)

Russian asset prices would fall immediately.

• 
  Stock market values collapse
  

• 
  Asset markets that were not destroyed would close. Thus, the price decline would show up in harder-to-observe ways, often with offers to sell and no buyers.
  

• 
  Capital flight and decline in value of the ruble.
  
• 
  Rising prices for commodities where Russia is a major producer.
  

• 
  Oil (modestly)
  
• 
  Gazprom produces a fourth of world natural gas output. It only exports a modest share, but that share is hard to substitute in the short run for its specific customers.
  
• 
  Russia is a major exporter of some metals: for example, aluminum, palladium, platinum, nickel, rhodium, and diamonds.²
  

• 
  If the currency fell 25-50%, no amount of buying could or should offset the decline. That is, Russian fundamentals are worse and many investors will want to sell Russian assets. Prices will need to fall.
  
• 
  If the currency crashed by more than half (as in Indonesia in 1997-98), panic is probably part of the problem. Thus, some Western government purchases might be called for.
  

• 
  Such purchases might avert a panic that would otherwise lead to a Russian hyper-inflation.
  

• 
  The Indonesian 75% real depreciation of the rupiah in 1997-98 led to 100% inflation in 1998, although not to persistent hyper-inflation.
  

• 
  Such purchases might make money (if fundamentals fells by less and the collapse was driven by panic)
  
• 
  Policy advice: The Fed and Treasury should work with other nations to prepare contingency plans if any currency loses more than half its value suddenly or otherwise appears to be driven by panic more than by fundamentals.
  

In the short run (10 days)

Movement of people will be rapid.

• 
  Lots of people fleeing the outskirts of Moscow
  
• 
  Lots of people fleeing other salient cities; most notably, St. Petersburg.
  
• 
  Lots of people fleeing Chechnya, fearing massive retaliation.
  

More financial repercussions.

• 
  Insurance companies in Russia would probably go bankrupt.
  

• 
  Policy point: All the world has an interest in geographically concentrated risks having world-wide reinsurance.
  

Critical uncertainty: The political response

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  Scenario A1: Political takeover by the military and/or ex-KGB.
  

• 
  End of democracy, although a few symbols might remain.
  

• 
  Scenario A2: At the same time, there could be government turmoil as the Center is physically not present and many government, military and ex-KGB leaders are now dead. In this scenario, destruction of the Center leads regions to have more independence.
  
• 
  Scenarios A1 and A2 can happen in tandem, with some regions leaving the new military dictatorship of Russia.
  

Over the next month the flow of goods and people will slow

• 
  Checkpoints into and out of major cities slow commerce.
  

• 
  Checkpoints act like a tax on all regional trade.
  

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  Explicit inspection fees
  
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  Bribes and informal fees
  
• 
  Costs of delays
  

• 
  Productivity will decline.
  

In a year

• 
  The economy will suffer very large inflationary shocks:
  

• 
  The collapse of the ruble will increase the cost of imported goods and the ruble cost of goods that trade on global markets:
  

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  Most notably, wheat and energy.
  

• 
  The reduction in inter-regional trade will lead to
  

• 
  local monopoly power
  
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  lower productivity
  

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  Scenario A2 and a weaker central government: Tax revenue to the central government declines rapidly at the same time that government spending on the military increases rapidly.
  

• 
  The central government is likely to resort to printing money at this point.
  
• 
  These forces can lead to hyper-inflation.
  
  
  

• 
  Scenario A1: The military or ex-KGB takeover will probably be accompanied by a roll-back of privatization. This roll-back may lead to higher prices and lower competition.
  

• 
  At this point a military regime is likely to impose price controls
  

• 
  As in the USSR, a likely results would be low inflation coupled with massive shortages and black markets.
  
• 
  The suppression of the market without adding any planning may further reduce production.
  
  
  

• 
  If there are perceived to be lots of loose nukes, the macroeconomic effects are amplified by an investment collapse as most rich people and foreign investors flee Russia with as much capital as possible.
  

What happens to the world economy?

1 day: Asset prices react rapidly

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  A “flight to quality” in terms of global assets as capital flees to safety.
  

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  Lots of purchases of US government short-term securities.
  

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  Some reduction in US short-term interest rates
  
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  Strengthening of the US$.
  

• 
  Gold prices rise.
  
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  Swiss franc rises
  

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  Most risky assets would have price declines.
  
  • 
    Insurance company stocks take a hit.
    

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  The predictable exception is a surge in price of stocks selling survival supplies, military contractors, technologies that detects nuclear weapons, etc.
  

• 
  Insurance gets more expensive
  
  • 
    Property insurance rises the most.
    
  • 
    Financial derivatives that provide insurance on assets (such as options that cover downside risk) rise in price.
    

• 
  The cost of lost productivity in the US on the first day is not economically significant. Nobody sees the effect of July 4 or Labor Day in the economic statistics. A few days of absenteeism or time spent watching CNN is round-off error in the U.S. macroeconomy.
  

10 days

• 
  Russia is a small part of the world economy. Thus, the first-order impacts of a collapse are small in terms of global supply or demand.
  

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  Lower expected oil supplies from Russia would put slight upward pressure on oil prices.
  

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  Some capital flight from the rest of former USSR and perhaps Central Europe. Risk premia and interest rates rise in such markets.
  

• 
  Critical uncertainty: How far would contagion spread to other emerging markets?
  

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  The closer to Russia geographically, politically, and economically, the more contagion.
  

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  Former Soviet republics will almost surely will suffer contagion.
  
  • 
    These nations have high trade with Russia.
    
  • 
    Thus, they will suffer from declining exports after the Russian economic collapse, amplified by higher costs of trade due to more Russian customs inspections
    
• 
  Central Europe will have weaker effects due to lower ties through trade.
  
• 
  Latin America and East Asia will probably not be affected directly.
  
  • 
    Most contagions are “connected” by geography and/or economic fundamentals.
    
  • 
    1997 contagion from Thailand to Russia, Brazil, etc. was the exception to the rule.
    
  • 
    Critical uncertainty: 1997-98 shows that contagion can skip continents, even when fundamentals are not closely linked. It is not clear why there would be a global run on emerging market debt, but it is possible.
    
    
    

• 
  The perceived source of the nuclear device (e.g, Pakistan or Iran) might suffer rising perceived risk.
  
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  South Korea suffers as fear that the nuclear threshold has declined. Also rising risk if the perception that North Korea supplied the device raises fears of a Russian attack on North Korea.
  

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  Outflow of people from Seoul.
  
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  Decline of the Korean stock exchange
  
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  Weakening of the Korean currency.
  

100 Days

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  Big slowdown in shipping as U.S. and others customs services seriously monitor incoming containers.
  

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  Jolt downward to production as ships back up outside ports and JIT (just-in-time) manufacturing plants must halt production as they await parts.
  
  
  

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  Massive decline in travel.
  

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  Decline in value of airline stocks.
  
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  Some bankruptcies and lots of job loss in travel-related sectors.
  
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  Much lower declines for “nearby” attractions as people vacation in Disneyland instead of Tahiti or Greek islands.
  

1000 Days

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  Slower travel and higher customs fees acts like a tax on trade. Over time, a slowdown in productivity as globalization slows.
  

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  Introduction of efficient detectors of nuclear weapons at major ports will reduce delays over the years after an attack.
  
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  The various costly security measures after 9/11 do not have a measurable effect on global productivity trends.
  

• 
  If the crisis is confined to Russia, the global macroeconomic effects will not be large or long-lasting.
  

Would the West fears loose nukes?

There are many reasons that Western perceptions of the number of loose nukes could rise.

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  Whoever provided the Moscow device may provide devices to other terrorist groups.
  
• 
  In Scenario A1 Russian regions are becoming more independent. Westerners may fear that local military commanders control nukes.
  

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  Locals could use them for local conflicts.
  
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  Of more concern to the West, locals could sell them to terrorists.
  

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  In Scenario A2 the Russian military or former KGB takes over. It is common for military regimes to use anti-Western rhetoric to legitimize their government. Westerners may perceive a return to Cold War risks.
  
• 
  Any specific signal that nukes are loose would amplify these perceptions.
  

• 
  Any second blast, particularly outside of Russia, would (obviously) increase fears of loose nukes.
  

Scenario B: What if the West fears loose nukes?

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  Reduction in real estate prices in salient central cities:
  

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  If there is a fear of Chechnyan nukes, then both population and real estate prices will drop in St. Petersburg, and other main Russian cities.
  
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  If there is a perception that anti-Western forces have nukes, the most salient are probably Manhattan, Washington DC, and London.
  

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  If there is a publicized specific and credible threat, we’d see a panicked outflow of people from threatened cities.
  

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  I assume the Department of Homeland Security has plans for a rapid evacuation, although Katrina shows how hard an evacuation can be even with several days’ notice. The Red Cross is used to helping a million Floridians move to shelters. I have no idea how prepared they are to help 3 million New Yorkers. They and Homeland Security have presumably given that possibility some thought.
  

• 
  Policy advice: The Red Cross and Homeland Security should plan for half of Manhattan or DC to want to leave in a hurry.
  

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  Stockpile potassium iodide and chelating agents nearby so exposed people can flush some radiation. Have plans to inform people to stay indoors or out of the nuclear plume (not get caught in gridlock).
  
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  Make sure responders can coordinate.
  
  • 
    Esp. as a big attack will bring in firefighters, doctors, etc. from many states.
    

Would insurers stop covering commercial real estate in some major metropolitan areas?

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  Yes, but probably only if there were signals of other loose nukes and only for risks relating to terrorism.
  
• 
  You asked: Would that put a serious damper on urban construction?
  

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  Only moderately, as most builders would expect the US government to provide insurance after a massive attack.
  

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  You asked: Does that loss of insurance intersect uncomfortably with urbanization in developing countries -- notably China?
  

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  No. A nuclear attack without insurance would still not be one of the major risks of doing business in China.
  

Scenario B′: Global equity investors become spooked.

Critical uncertainty: Perceptions of attack on the West

The Moscow attack will have strong global effects if Westerners fear an attack on a major Western city. Here is a rough ranking of what would raise the odds of a Western economic crisis, all roughly correlated with rising perceptions of loose nukes that might attack the West:

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  Evidence of non-Russian nukes
  
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  Evidence al Qaeda has nukes
  
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  Nuclear attack outside of Russia: Israel, Iraq, South Korea, Pakistan, etc.
  
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  Unsuccessful nuclear attack against DC, NY or London
  
• 
  Successful nuclear attack against DC, NY or London
  

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  Could be a major loss of confidence among global investors.
  

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  Exit from global equities.
  

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  Surge in price of gold and stock market collapse.
  

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  Reduction in global investment.
  

• 
  Chance of a collapse of the US dollar as it is no longer a safe haven.
  

• 
  A sharp dollar decline is likely in the next few years regardless of a nuclear attack. Thus, this section is a bit generic.³
  
• 
  US dollar depreciation implies an enormous capital loss for China, Taiwan and other nations with billions of assets denominated in U.S. dollars.
  

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  Any initial dollar slump may lead these nations to want to diversify their portfolios.
  
  • 
    Such diversification implies selling dollars to buy euros and to a lesser extent yen.
    
  • 
    This selling, in turn, can amplify the downward pressure on the dollar.
    
    
    
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  A weaker dollar makes imports more expensive, so U.S. inflation heats up.
  
  • 
    Fed raises interest rates to fight inflation (and perhaps to try to stem a dollar panic).
    

• 
  The Fed knows about one-time shocks such as rising import prices and will try not to over-react. At the same time, if nobody wants to hold U.S. bonds, interest rates in the United States must rise.
  
• 
  Policy advice: The U.S. Treasury and the Federal Reserve should have contingencies for $300 billion of U.S. bonds arriving suddenly on the market.
  
  
  

• 
  Rising interest rates could lead to a large slump in the United States.
  
  • 
    The slump will be amplified if housing prices decline sharply. This risk that is greatest the coasts, where prices have risen the most since the mid-1990s. When people have large loans relative to now-lower housing prices, some will default. This defaulting will be amplified because some homeowners have loans that require them to refinance, but now will have mortgage greater than now-lower house values. Again, they will default. A debt-deflation is possible in housing.
    
  • 
    Policy advice: Regulators should discourage home loans that make systemic defaults likely; specifically, those with very low down payments, high interest rate risk, and requirements for large refinancing in a few years.
    
    
    
• 
  Loss of dollar as the almost-exclusive global reserve currency reduces US seignorage (the “profit” the U.S. makes as foreigners hold our dollars or short-term U.S. T-bills without requiring much interest). This effect modestly raises the U.S. government deficit.
  
  
  
• 
  Weaker dollar means that Japan will (once again) slowdown.
  
  • 
    Japan has had a decade of big government deficits so have little room for expansionary fiscal policy.
    
  • 
    Japan has had very low nominal interest rates, so little room for expansionary monetary policy.
    

• 
  Japan may target a stable $:yen rate (that is, yen falls along with US$), which will help keep next exports going.
  
  
  

• 
  Chance of evacuation or attack on New York. New York City is an obvious target due to its symbolic and economic importance as the center of capitalism.
  

• 
  Especially since 9/11 most large financial institutions have been preparing for a disaster in Manhattan.
  

• 
  Policy advice: The Federal government should check the contingency plans of the largest banks, brokerages, etc. They should be able to demonstrate continuous back-up of all records and the ability to continue transactions within a few days.
  
• 
  Regulators should require life insurers to analyze worst cases for robustness and reinsure high risks. http://www.air-worldwide.com/_public/html/air_currentsitem.asp?ID=709
  

• 
  The New York Stock Exchange (NYSE) is a crucial institution that has historically used human traders to “make the market” in the stocks of most of America’s largest companies. It is essential an alternative exchange (either a new human or electronic NYSE, or the existing NASDAQ, London or Tokyo exchanges) be prepared to trade NYSE shares within a few days of the physical NYSE closing down.
  

• 
  Policy advice: The Federal government (Fed, Treasury, SEC) should double-check that financial markets have contingency plans for reopening in new physical or virtual locations.
  

China scenarios

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  China has several choices after the US dollar loses much of its value.
  

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  China stays pegged (mostly) to the dollar so that yuan weakens against the euro and yen.
  

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  Inflationary shock in China.
  
• 
  Lower purchasing power of Chinese consumers.
  
• 
  Surge of Chinese exports and reduction of Chinese imports anger EU and Japan.
  
  • 
    Plausible protectionist pressure in EU and Japan.
    

• 
  China revalues to maintain its average value against, weakening a bit against the yen and euro and strengthening moderately versus the dollar.
  

• 
  This would be a sensible policy.
  

• 
  China floats the yuan and it maintains its average value would have no big effect.
  
• 
  Wild card: China floats the yuan and the Chinese currency appreciates (that is, gains in value) enormously against the dollar, euro and yen.
  

• 
  Lower net exports from China could lead to a big recession there.
  
• 
  Lower profits would make more companies refuse to pay bank loans.
  
• 
  Bankruptcies might put some banks out of business. A collapse of credit could trigger more bankruptcies, leading to a serious debt deflation.
  
  • 
    That is, falling stock market and real estate prices make firms less creditworthy.
    
  • 
    Banks take possession of assets after bankruptcy and sell them.
    
  • 
    Lots of asset sales put further downward pressure on asset prices.
    
  • 
    And the process spirals to economic collapse.
    

• 
  Think US 1929, Indonesia 1998, etc.
  
  
  

• 
  Wild card – very speculative. Chinese Communism is no longer a unifying ideology for many Chinese. At the same time, it is difficult to mount a serious challenge to the current government as long as GDP per capita doubles each decade. Conversely, it is possible a deep recession could lead to political collapse in China. A related example is how the 1997-98 Indonesian financial crisis led to the end of Suharto’s regime.
  

• 
  China has lots of pressures to fragment into regions.
  
  • 
    Tibet, Taiwan, Muslim east, prosperous Pacific coast, etc.
    
• 
  The only legitimate force may be the Red Army. A new centralizing military government would probably be nationalistic.
  
  • 
    Threats to Taiwan, etc.
    
• 
  Note: I fear a Chinese recession can lead to political instability in the next few years, regardless of a nuclear attack. Thus, this section is a bit generic.
  
  
  

What can be done to minimize the intensity and duration of an inevitable economic downturn?

Japan has spent 15 years exhausting its central government’s line of credit. Thus, expansionary fiscal policy is unlikely to be helpful in pulling Japan out of any recession.