As Europe awoke to the news that Russia has launched military action against Ukraine, it is hard to avoid the conclusion that the geopolitical tectonic plates have shifted. A war on this scale in continental Europe is not something we have seen since 1945 although we should not forget that the Soviet Union did invade Hungary in 1956 and Czechoslovakia in 1968, so there is a parallel (albeit inexact). Twenty years ago it all seemed very different. Having experienced a form of shock therapy following the collapse of the Soviet Union in 1991, which saw hyperinflation and a huge collapse in output, the Russian economy stabilised in the late-1990s. Accession to the G8 in 1997 gave rise to hopes that it would become a reliable international partner whose political and economic interests would be more aligned with the west. The annexation of Crimea in 2014 changed all that.
From a geopolitical perspective, Russia has become an increasingly difficult problem for the west to manage. To quote the British parliamentary Intelligence and Security Committee, “Russia is simultaneously both very strong and very weak.” It is a significant military player with a permanent seat on the UN Security Council. Yet it has a relatively small population compared to the west and a weak economy which is heavily reliant on hydrocarbon revenues. This makes it difficult to respond effectively. Military engagement by the west in Ukraine is out of the question, although matters could escalate if former Soviet Republics which are now NATO members (Estonia, Latvia and Lithuania) face a similar threat. That is something we would rather not think about. But as a response to the Ukrainian incursion, it is clear that the west will implement economic sanctions.
Germany has already paused its certification of the Nord Stream 2 gas pipeline. Whilst this does not mean that the pipeline will never be used, it is a significant move and will have major implications. Although Chancellor Scholz wants to wean Germany off imported Russian gas, the view in Moscow is this will be impossible in the short term and may not even be possible on a 5-10 year horizon. This is indeed plausible and the 2011 decision to end nuclear energy generation now looks rather ill-judged. However, now that the Greens are part of the government coalition, their resolve to further reduce dependency on fossil fuels should not be underestimated. Either way, this is likely to have significant costs for one or both parties – we cannot predict at this point where the incidence will fall.
How effective will sanctions be?
The German case was merely the most high profile of a range of sanctions introduced in recent days (the British government’s efforts were a particularly weak response) and more will be forthcoming. Sanctions are now regarded as the first response to aggressor nations and in contrast to the old maxim of “shoot first and ask questions later”, the Peterson Institute for International Economics (PIIE) acknowledges that “advance planning for the imposition of sanctions is now the norm.” But what are they designed to achieve? There are a range of possibilities. Sometimes they are simply implemented to satisfy domestic considerations rather than influence the actions of others; they may be designed to send a signal that the actions of others are unacceptable, or they may be intended to implement regime change. Whether or not sanctions are successful depends on which of these is the intention.
A study by PIIE suggested that sanctions tend to be effective in roughly one-third of cases. But the success rate depends very much on the objectives. “Episodes involving modest and limited goals, such as the release of a political prisoner, succeeded half the time. Cases involving attempts to change regimes (e.g., by destabilizing a particular leader or by encouraging an autocrat to democratize), to impair a foreign adversary’s military potential, or to otherwise change its policies in a major way succeeded in about 30 percent of those cases. Efforts to disrupt relatively minor military adventures succeeded in only a fifth of cases.” The invasion of Ukraine is not a “minor military adventure” so the odds that sanctions will reverse the outcome are limited. In any case, as PIIE notes, “sanctions are of limited utility in achieving foreign policy goals that depend on compelling the target country to take actions it stoutly resists.” US efforts to promote political change in Iran and Cuba are testimony to this. Furthermore, according to PIIE: “It is hard to bully a bully with economic measures” since the evidence suggests that democratic regimes are more susceptible to such pressure than autocracies.
In order to manage expectations, western governments have to make it clear at the outset that they do not expect economic sanctions to facilitate regime change in Russia or reverse the Ukrainian invasion (although Putin did suggest in his speech that Russia does not intend to occupy Ukraine). What kind of sanctions could the west impose? The first option would be to sanction the free flow of Russian capital by imposing restrictions on those with close links to the government, the rationale being that pressure placed on Putin by power brokers would destabilise his grip on power. This would include restrictions on their personal activity and also the banks that they use.
There have also been calls to cut Russian access to SWIFT, the global interbank payments system. Whilst this would severely impact on Russian banks, European creditors would also struggle to get their money out of Russia. This would be particularly problematic since BIS data indicate that European banks hold the vast majority of foreign banks' exposure to Russia (chart above). Russia also has huge FX reserves, totalling around $630 billion, which would mean that it has no immediate need for market access to foreign currency. It also has its own financial payments system (SPFS) which funds around 20% of Russian settlements. However, the Atlantic Council think tank reckons that “the Russian equivalent of SWIFT remains mostly aspirational [and] is much ado about nothing,” concluding that its importance is overblown.
One concern is that sanctions on Russia could drive it further into China’s orbit as the two countries have become closer in recent years as they seek to weaken US hegemony. But China has to balance its relationship with Russia against its need to preserve relationships with the west and it has nothing to gain from any conflict with Ukraine. However, closer Chinese ties may weaken the impact of any economic sanctions that the west might impose (for example, if China were to become a bigger importer of Russian oil and gas).
Implications for the west
Thirty years ago much of the talk in policy circles was of the peace dividend that would accrue as a result of reduced defence spending. That dividend now appears to have been used up and recent events may force governments to think about raising defence spending. Only seven of the 30 NATO members currently spend more than 2% of GDP on defence – the benchmark which all members are meant to achieve by 2024. Increased defence spending will stretch public finances more than in the period 1945-90 because ageing populations mean that health services are a bigger competitor for tax revenue. It is therefore possible that taxation will have to rise in order to pay for it.
More generally the era of peace, prosperity and openness characterised by increased globalisation is apparently in retreat (see the KOF index). Russia may not be the superpower of old but it is big enough to cause problems if it flexes its muscles. China waits in the wings, perhaps assessing the west’s response to the Ukrainian invasion as it ponders how to deal with Taiwan. For those of us old enough to remember the Cold War, none of this is new. Nor does it necessarily mean huge changes in the way we live our day-to-day lives. But governments will have to make increasingly difficult choices about resource allocation as we revert to a world of “them and us.”
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