Putin Is Going to Lose His War
And the World Should Prepare for Instability in Russia
Over the last three weeks, the Russian economy has been overwhelmed by sanctions. Soon after the Kremlin invaded Ukraine, the West began seizing the assets of the wealthiest individuals close to Russian President Vladimir Putin, prohibited Russian flights in its airspace, and restricted the Russian economy’s access to imported technology. Most dramatically, the United States and its allies froze the reserve assets of Russia’s central bank and cut Russia out of not just the SWIFT financial payments system, but of the basic institutions of international finance, including all foreign banks and the International Monetary Fund. As a result of the West’s actions, the value of the ruble has crashed, shortages have cropped up throughout the Russian economy, and the government appears to be close to defaulting on its foreign currency debt. Public opinion—and the fear of being hit by sanctions—has compelled Western businesses to flee the country en masse. Soon, Russia will be unable to produce necessities either for defense or for consumers because it will lack critical components.
The democratic world’s response to Moscow’s aggression and war crimes is right, both ethically and on national security grounds. This is more important than economic efficiency. But these actions do have negative economic consequences that will go far beyond Russia’s financial collapse, that will persist, and that are not pretty. Over the last 20 years, two trends have already been corroding globalization in the face of its supposedly relentless onward march. First, populists and nationalists have erected barriers to free trade, investment, immigration, and the spread of ideas—especially in the United States. Second, Beijing’s challenge to the rules-based international economic system and to longstanding security arrangements in Asia has encouraged the West to erect barriers to Chinese economic integration. The Russian invasion and resulting sanctions will now make this corrosion even worse.
There are several reasons why. First, China is attempting to navigate a nonconfrontational response to the Russian invasion. Both its financial system and its real economy are observing the sanctions because of the potential economic retaliation if they finance or supply Russia, let alone bail Moscow out. But anything short of fully joining the blockade will feed anti-Chinese policies in the West, reducing the country’s economic integration. Second, countries fear being subject to the whims of Washington’s economic might, now that it is re-enamored with its apparent power. Right now, the United States’ economic actions may be just, and there may be little risk of countries not invading Ukraine ending up on the wrong side of U.S. policies. But the next time, the United States may be more selfish or capricious.
Finally, the damage sanctions are doing to the Russian economy and the substantial costs to central Europe if Russia cuts off its access to natural gas and oil in response may make governments pursue self-reliance and disentangle themselves from economic connections. Ironically, this will be self-defeating. Russia’s current sharp economic contraction shows just how difficult it is for states to thrive without economic interdependence, even when they try to minimize their perceived vulnerability. In addition, Russia’s attempts to make itself economically independent actually made it more likely to be subject to sanctions, because the West did not have to risk as much to impose them. But that will not stop many governments from trying to retreat into separate corners, looking to protect themselves by withdrawing from the global economy.
Pundits, of course, have cried wolf about such divisions for years, and the smaller countries that attempt to self-isolate will be unable to succeed. But it now seems likely that the world economy really will split into blocs—one oriented around China and one around the United States, with the European Union mostly but not wholly in the latter camp—each attempting to insulate itself from and then diminish the influence of the other. The economic consequences for the world will be immense, and policymakers need to recognize and then offset them as much as possible.
For all the talk about the “weaponization of finance,” the sanctions employed against Russia have been effective only because the international alliance imposing them has been broad and committed. Freezing the Russian Central Bank’s reserves, for instance, works only if the majority of the world’s financial system is on board with doing so. It is the alliance, not the finance, that has mattered. Since the anti-Russian alliance contains all the major financial institutions except the Chinese banks—and since Chinese banks do not want to be shut out of that system—the financial sanctions will not lead to any fundamental changes in the world’s monetary or financial order.
Economies that feel threatened by Washington do now have an incentive to shift their reserves out of holdings in the United States. In theory, this has always been a check on Washington’s overuse of financial power; if the country sanctions too frequently, it might induce other states to come up with better alternatives to the dollar and to the payments system around it. And over the very long term, a divided world economy under the threat of sanction will bend in that direction. But in the meantime, what Russia demonstrates is that diversifying into euros, yuan, and even gold will not help states if other market participants are themselves afraid of being shut out of the dollar system, because there will be no other party for them to sell their reserves to. Cryptocurrencies are going to have to decide whether they will observe sanctions and thus lose some of their users (who treat the currencies as a refuge) or whether they will facilitate attempts to elude sanctions, in which case governments are likely to shut down or marginalize them.
The Chinese yuan will struggle to become a major alternative to the dollar, even for economies in Beijing’s bloc. As long as China prevents people from freely taking assets out of its domestic financial system, investors and even central banks that adopt it would just be trading Washington’s sanction threats for Beijing’s. Beijing could work around this problem by making the yuan freely convertible, rather than tightly controlled. But if that happened, the value of the yuan would likely decline sharply for an extended period, as it did from 2015 to 2016, when China temporarily opened its capital account, because billions of people who hold their savings in China are desperate to diversify their portfolios by moving their assets elsewhere in pursuit of higher returns. China could, of course, become the reserve currency for the small economies it dominates and for pariah states—countries with no real alternative. But this would do little to diversify or create preferential returns for Chinese savings, and it could backfire by entangling China’s financial system in other states’ financial instability.
That does not mean nothing will change financially. The more that economic divisions are amplified by hard-power divisions, the more that governments will align their financial systems with their primary military protector. Exchange-rate pegs tend to follow military alliances (as I established in 2008). The world saw this throughout Africa, Latin America, and South Asia during the Cold War, as governments switched the focus of their exchange-rate targets or currency pegs when realigning between the Soviet Union and the United States. But although that may mean some countries move in and out of the de facto dollar zone, it will not create an alternative currency that is attractive on its own terms.
The invasion and sanctions, then, will not result in enormous financial changes to the global economy. But they will speed up the corrosion of globalization already underway, a process that will have broad impacts. With less economic interconnectedness, the world will see lower trend growth and less innovation. Domestic incumbent companies and industries will have more power to demand special protections. Altogether, the real returns on investments made by households and corporations will go down.
To see why this is, consider what may happen to supply chains. Currently, most industrial companies and retailers source each key input or step in their production processes from a single or handful of separate places. There was a powerful economic logic to setting up global supply chains this way, with relatively few redundancies: not only did they save on costs by encouraging firms and factories to specialize, they also increased the scale of production and provided local marketing and information advantages. But given the current geopolitical and pandemic realities, these global value chains may no longer be worth the risk of relying on specific choke points, particularly if those points are in politically unstable or undependable countries. Multinational companies, with government encouragement, will rationally insure against problems by building redundant supply chains in safer locations. Like any form of insurance, this will protect against some downside risk, but it will be a direct cost that yields no immediate economic returns.
Meanwhile, if Chinese and U.S. companies no longer face competition from each other (or from companies outside their economic bloc), they are more likely to be inefficient, and consumers are less likely to get as much variety and reliability as they currently do. When that consumer is the government, protected domestic firms are even more likely to engage in waste and fraud, because there will be less competition for government procurement contracts. Throw in nationalism and fears of national security threats, and it will be easy for such companies to cloak themselves in patriotism and take it all the way to the bank, knowing that they are politically too big to fail. There is a reason why closed economies are more likely to experience corruption.
The world will see lower growth and less innovation.
Analysts can already see this at work in seemingly patriotic commitments by President Joe Biden and former President Donald Trump about “onshoring” manufacturing—relocating the supply chains that make U.S. goods so they take place in the United States. They are using national security and pride to justify policies that shortchange both national defense and the 85-plus percent of U.S. workers not employed in heavy industry. The fetishizing of domestic manufacturing over advancing cross-border trade in services and networks is especially ironic, given that the latter sectors are what has truly advantaged the West over Russia in implementing effective sanctions, and what has deterred Chinese businesses from bailing Russia out.
Similarly, the corrosion of globalization will have negative consequences for technology. Innovation is faster and more common when the global pool of scientific talent is engaged and can exchange ideas and share proof, or disproof, of concepts. But there is a politically compelling reason for states to try to make sure that only allies have access to their technology, even if restrictions are of dubious military relevance (in a world of cyberespionage, it is easy to acquire technological designs). The likely result will be a decline in innovation, as U.S. and other Western research institutions deprive themselves of many talented Chinese and Russian students and scientists.
The intensified corrosion of globalization will further diminish the return on capital in the world economy, and it will do so on every side of the economic divide. There will be new limits on where people can invest their savings, driving down the range of diversification and average returns. Fear and nationalism will likely increase people’s desire for safe investments at home, in government or publicly backed securities. Governments will also combine national security arguments with fiscal and financial stability measures designed to strongly encourage investment in their own public debt, as they do during wars.
There is one beneficial economic side effect to the increasing global divisions: the European Union is being galvanized to unify more of its economic policies. The bloc is putting up joint resources to share the financial burden of the massive Ukrainian refugee inflow coming into Poland and other eastern members. European bonds are being issued to pay for these measures, rather than individual member state debts.
The European Union or eurozone may issue more European public debt in the future, which would further help the global economy. The Russian invasion reinforces the fact that this is a world of low returns, and many investors have a high desire for safety. By creating more safe assets for them, the EU and eurozone can absorb some risk-averse savings, improving financial stability.
Stronger EU unity will also create new opportunities for growth. Led by Germany’s Chancellor Olaf Scholz, almost every EU member has made a multiyear commitment to increased defense spending and a greater public investment in rapidly reducing the continent’s dependence on Russian fossil fuels. Both of these investments will go a long way toward ending Europe’s free-riding on the United States and China for growth; giving the global economy another engine will help balance out the ups and downs of the business cycle, stabilizing the world against recessions. It will also prevent the faster-growing economies from running up foreign debt as they have when Germany and other European surplus economies exported products but failed to consume.
These initiatives will, in particular, help the eurozone itself. One of the primary causes of the euro crisis a decade ago were the imbalances among euro economies caused by German austerity. By increasing German domestic demand, southern members of the eurozone will be able to work off some of their debt through increased exports rather than having to cut back wages and imports to make their payments. This should strengthen the long-term viability of the euro, as well as increase its attractiveness to potential new members in eastern Europe and reserve managers around the world. A euro that is less subject to internal tensions and worries will also be of higher, more stable value, which in turn will reduce trade tensions with the United States.
Unfortunately, the Russian invasion will prove to be far less kind to the developing world. Food and energy price hikes are already hurting the citizens of poorer states, and the economic impact of corroding globalization will be even worse. If lower-income countries are forced to choose sides when deciding where they get their aid and foreign direct investment, the opportunities for their private sectors will narrow. Companies within these countries will grow more dependent on government gatekeepers at home and abroad. And as the United States and other countries increase their use of sanctions, firms will be less likely be less likely to invest in these economies. Anxious multinational companies want to avoid U.S. opprobrium, and so they will forego investing in places that they see as having undependable transparency.
The saddest part of this is that it comes on top of the world’s unequal response to COVID-19, in which high-income countries did not provide enough vaccines and medical supplies to the developing world. This political disregard for the well-being of low-income populations globally materially changes the economic conditions on the ground. That in turn provides a commercial justification for the private sector not to invest in those economies. The only way out of this cycle is through public investment and enforced, fair treatment. Division among the major economies, however, is likely to make such investment in the developing world insufficient, unreliable, and arbitrarily disbursed.
Helping poor economies is not the only long-term, development goal that Russia’s invasion puts at risk. To survive, societies around the world will need to mitigate and adapt to climate change, but the pivotal role of Russia and Ukraine in global energy supplies sends out contradictory forces that will make the energy transition more challenging. Simultaneously, Western politicians are calling for moving away from greenhouse gasses and advocating increased fossil fuel exploration outside Russia. States want to prevent price gouging, cut energy taxes, and compensate households for higher gas prices, but they also want to increase incentives to expand greener energy production and decrease consumption, which require higher prices. The tradeoffs extend beyond climate change. Democracies want to build alliances around liberal values and freer markets, but to cut energy costs, they are going to autocratic governments such as Saudi Arabia and Venezuela, offering to legitimize their regimes in exchange for increased oil supply.
Underlying all this is an inconvenient reality: to slow rising temperatures, the world needs international collective action, including from China. The alliance of democracies cannot do it alone. The Chinese and the U.S. governments have, at times, been able to make joint progress on climate initiatives even while being in conflict on other issues, and both Chinese President Xi Jinping and Biden have said they want to do so again. But it will get harder as each country retreats into a separate bloc. Meanwhile, as the corrosion of globalization reduces the pace of innovation by restricting research collaboration, it will also become more challenging for scientists to come up with a deus ex machina that can save the planet.
Stopping the corrosion of globalization was already difficult, and the Russian invasion of Ukraine makes it harder. As politicians in the United States and elsewhere spin false narratives about how economic openness is bad for workers, the Russian invasion and the resulting sanctions push China and the United States further apart.
But policymakers are not helpless. The financial sanctions on Russia were so powerful because they were imposed by a strong alliance of higher income democracies. If Australia, Japan, South Korea, the United Kingdom, the United States, the European Union, and other important market economies can channel the same might they used to punish Russia toward helping the economy, they can repair the erosion—perhaps encouraging China to stay connected as well.
To do so, officials must pursue a wide range of policies. They can start by making a common market among democracies that is as broad and deep as possible—including for goods, services, and even labor opportunities. They must create common standards for screening cross-border private investment for national security and human rights reasons. They should create a relatively even playing field among allies that can foster healthy competition, which would diminish the worst side effects of economic nationalism: corruption, the entrenchment of incumbents, and waste. Policymakers must also set up a sustained, multiyear public investment front across the Western alliance, which would reduce imbalances between economies and raise overall returns on investment.
The world’s democracies cannot reverse every corrosive division in the global economy caused by Russian aggression and China’s tacit approval. They should not want to; some forms of violence must be met with economic isolation. But they can make up for many of the losses, steadying the planet in the process.
Harsh Sanctions Could Make the Country a Bigger, Badder North Korea