Last week, as Russia invaded Ukraine, the U.S. and its European allies unleashed a variety of economic penalties in response. Saturday, the coalition added additional penalties, limiting the Russian central bank’s access to reserves, and barring Russian banks from a key financial messaging system.
While the sanctions regime has some big holes in it—by design—it is nonetheless likely to be highly effective in its intended direct effect of damaging the Russian economy. Conversely, although Putin had prepared in recent years to insulate his economy from sanctions, that attempt is likely to fail; many of the economic defenses for the so-called "Fortress Russia" will prove useless.
Here are five reasons why the economic war will be extremely one-sided.
Reason One: the parable of the phone charger
One of the most universal annoyances of modern life is getting temporarily stuck without your phone charger. A phone charger isn’t costly or hard to replace in the long run. But when you are in an airport and a sudden cancellation forces you to reroute your itinerary, the loss of something small and cheap can become a disaster.
This is how a lot of sanctions against Russia are playing out. Little tiny components of everyday life have suddenly gone missing without warning and without any time to prepare. I wrote last week about the basic strategy of sanctions: you want to cause much greater inconveniences to your target than to yourself.
A key weapon here is financial technology platforms. A wide variety of transactions made in Russia actually have hidden dependencies on financial systems based in the U.S. or Western Europe. Suddenly, all of those have been called into question. Little conveniences like Apple Pay stopped working for many customers; per one observer, this contributed to congestion at the Moscow Metro.
I discussed correspondent banking last week; customers of Russian banks are going to find international transactions difficult or impossible due to the lack of middleman services that connect them with banks abroad. And things got harder from there. On Saturday, Russia lost access to the Society for Worldwide Interbank Financial Telecommunication (SWIFT) system, which banks use to communicate with each other about how much money is owed, and to whom.
This sounds somewhat trivial, and in a way, it is. For most people, it works smoothly and you don’t have to think about it. But banks can’t simply send their money away without verifying information about the recipient, and that verification becomes a great deal more difficult if you don’t have access to your usual tools. You can use less efficient, older tools. You could code a different system eventually. But a sudden loss of functionality—especially, the loss of the tool that everyone else uses—is a huge inconvenience timed perfectly to coincide with a moment of financial turmoil in Russia.
Reason two: when you’re an outlaw they can just take your stuff
In liberal economies, there is normally a strong presumption that property can’t be arbitrarily taken away. Sure, you could be fined or sued and lose money that way, but only through a system of laws and precedents.
If you have money, you are thought to have a right to use it, especially if the money is parked at a reliable institution like the New York Fed. Also—though this is less important—if you own a big boat, that is also yours to hold onto.
This system of solid, reliable property rights is usually the right strategy. While it might seem temporarily advantageous for the government to seize money or boats, a profitable “betrayal” like that would have deleterious consequences in the longer run. (Game theory, a branch of economics, often validates betrayal as an advantageous strategy in a one-off game, but not in a more permanent relationship where credibility is important.)
If currency isn’t a reliable store of value, people won’t feel comfortable using it and its value will plummet. And if possessions aren’t protected by law, people won’t feel comfortable buying things in your country. A system of commerce depends on the idea that once you own stuff, you own it.
And yet, the White House and its allies are forcefully rejecting that foundational idea with respect to Russia, rendering their central bank’s assets inaccessible and threatening to confiscate the yachts and mansions of high-level Putin cronies.
Under ordinary circumstances, these kinds of “one-time” policies are disastrous because they are recognized as the tell-tale signs of an unreliable partner in repeated games. When you read about a politician confiscating property and seizing bank accounts, it is usually a sign that your money had better run for the exits.
But this is different. The U.S. has substantial reserves of credibility to draw on here. Few dollar users, if any, are likely to commit the same offenses as Russia or draw the same punishment. Furthermore, as European allies have joined the effort, there aren’t alternatives to the U.S. system.
In freezing reserves and oligarch assets retroactively while allowing future oil transactions to go through, the U.S. and European governments may succeed at a kind of policy coup, where some of Russia’s past accumulated wealth from oil exports gets confiscated, and yet, it still suffers no incentive to stem future oil production.
Reason three: strength in numbers
Russia’s predicament is financial and it has high stakes, but it is similar in some ways to the plight of high-profile provocateurs who get banned from social media networks. They staked a lot of their well-being on a platform they thought would be neutral, building a reputation there.
But then this mostly-neutral carved out an exception to crush a small fraction of its users it deemed ill-behaved. In general, whatever you think of the fairness of it, this strategy is astonishingly effective; the mostly-neutral platform still has an advantage of huge network effects and continues to be the best option for the vast majority of users, who have no fear of sanction. The small number of people with grievances against it—whether the grievances are legitimate or not—simply do not have the leverage to do anything about it.
Some commentators have suggested that these unprecedented actions could result in an opportunity for Chinese financial institutions, like its SWIFT alternative, the Cross-Border Interbank Payment System (CIPS), or even an opportunity to unseat the dollar as the world’s reserve currency.
Any of the more extreme claims here are deeply overstated. The fact is that the US has most of the world’s largest economies on its side. China is the world’s second largest economy at nominal exchange rates, and Russia is about eleventh. The top ten also include Japan, Germany, the UK, France, Italy, Canada, and South Korea, all of which are actively participating in the anti-Russia sanctions.
Financial commentators love talking about the dollar losing its status as reserve currency, because it gives them a permission structure to wildly speculate. But there is little constituency for a Russia-friendly financial system among the world’s largest economies. And for countries seeking a relatively neutral and rules-based system free of geopolitics, China isn’t a very good alternative anyway. (It has a variety of idiosyncratic foreign policy demands of its own, and regularly uses economic might to help reinforce them.)
Reason four: the iron law of foreign currency reserves
There’s a theme I talked about in my overview of Afghanistan’s economy last year that we can come back to. Foreign currency reserves and isolated regimes. One of the most iron laws of international economics is that there are only a few ways to pay for imports, and if you can’t use one of those specific methods, you have no way of getting them.
One of these is exports. Russia still has the capacity to export a lot of energy, and under the sanctions regime, it is allowed to do so. The coalition of U.S. and European economies left that out of the sanctions deliberately. So by no means is Russia entirely cut off from trade. But non-energy sectors will struggle to export efficiently with the new costs of international transactions created by the financial sanctions.
With respect to the other methods of paying for imports, Russia isn’t so lucky. You can purchase some imports if foreigners are willing to hold your currency, or assets denominated in it. If people are willing to buy and hold investments in your country, then you can use those financial instruments, rather than balanced trade, to finance imports. The U.S. does this a lot. If foreigners decide to increase their holdings of American stocks by $10 billion, that can finance $10 billion of imports for American consumers.
Under present circumstances, though, Russia doesn’t have as many valuable financial assets to trade away, and this is especially true after the sanctions. Many firms are winding down Russian investments voluntarily, and some are strictly prohibited. One section of the Treasury Department’s release last week is titled “Debt and Equity Prohibitions Against Major State-Owned and Private Entities.” Russia has valuable firms to invest in, and under normal circumstances it could use shares of those companies to functionally pay for imports. That option is being closed off.
The last option is to wind down your existing reserves of foreign currency. But as I discussed above, a lot of that is unavailable because those reserves were held at foreign central banks that have frozen their funds.
As a result, Russia’s ability to pay for imports (most importantly, advanced machinery and medicine) is going to be closely tied to how much it exports in return. As war eliminates more sophisticated forms of financing, international trade reverts to something resembling a barter system.
Reason five: Russia built the wrong style of fortress
Putin has been wary of the possibility of sanctions for quite some time. And it prepared for sanctions through a “Fortress Russia” strategy. One characteristic of that strategy was what the Financial Times’ Max Seddon describes as a “conservative fiscal policy.” For a long time, Russia worked to export energy, suppress consumption, and build up financial reserves.
This will prove to be a critical error. Financial reserves, as we’ve discussed above, aren’t nearly as immutable or rock-solid as they seem. Yes, it’s true that if you have a conservative balance sheet as, say, a value investor during a financial crisis, you can use a hoard of cash to buy up companies on the cheap. But ultimately a balance sheet is just a social construct, contingent on the cooperation of the U.S.-led financial system.
And that cooperation is no longer forthcoming. Reserves are being frozen and transactions are failing to go through. Dollars are just numbers on a computer screen, and can’t be counted on. If you end up as an economic pariah state—as Russia currently seems to be—nothing less than total autarky will do. I am not sure whether Russia’s economic advisors failed to understand this principle, or simply underestimated the ferocity of the economic response. But if they had been trying to prepare for war, they should have saved in terms of spare parts, supplies, and material self-sufficiency, not financial assets. When the tanks start rolling, only the physical balance sheet matters.