We Have Yet to See the Full Economic Costs of War With Russia

The first few weeks of the war in Ukraine brought a withering escalation by both Russia and the West. Russia unveiled a full-scale invasion against Ukraine, far in excess of the more limited actions in the Donbass that most Russians expected. The United States and the West then met Vladimir Putin’s step by unveiling unprecedented economic actions, capped by the effectual seizure of Russia’s foreign exchange reserves.

The economic war looks remorseless and condemned to its wealth-destroying trajectory. Shocks are likely to intensify in commodity markets concerned with energy, metals, and agriculture. Russia is a key supplier in all these sectors and has considerable market power. Russian intentions, to be sure, are not easy to discern, as its spokespeople have been angry but unsettled as to the response. Putin, however, called the seizure of Russia’s central bank assets “akin to a declaration of war.” It seems advisable to take this seriously.

A Deer in Headlights

A question immediately arises. Why was Russia left so exposed to the big freeze? Why should there be an enormous pile of Russian assets—$630 billion according to President Joe Biden, about $388 billion according to others—sitting in places where it could be expropriated? It seems a logical deduction that Putin was taken entirely by surprise by the extremity of the response. If he had anticipated the reaction, why then did he leave the Russian trust fund so vulnerable? The explanation, if we ever get it, may prove complicated, but the assumption that it was a big surprise seems right.

Like a deer in headlights, Putin did not have a response to the West’s use of weapons of financial destruction (WFD). But unlike Josef Stalin, who didn’t have a response planned when, notoriously, he refused to believe in the reality of Operation Barbarossa, thought it was a trick by provocateurs, then retreated to his dacha in isolation and silence for over a week after June 22, 1941, Putin has not gone into hiding. In fact, he has made regular public appearances, even as his economic war with the West remains less developed and publicized. A Blitzkrieg in the East, a Sitzkrieg in the West. Movement on the latter somehow has to be the next step in the unraveling of the plot.

The Russian response is generally clear—if you cut us off, we’ll cut you off—but somewhat vague as to specifics. Putin has declared an embargo on the export of certain commodities to the West, but Russia has yet to say which ones. Early in the crisis, former Russian president Dmitry Medvedev told Europe to get used to paying exorbitant prices for gas. Deputy Prime Minister Alexander Novak said on March 7 that Russia had “every right” to close the Nord Stream I pipeline in response to Germany’s termination of Nord Stream II, but has not yet done so. Natural gas contracts with Western Europe are being honored, according to Putin, but Russia has withdrawn from the spot market, resulting in prices for European gas last week that are seven times higher than the average U.S. price in December 2021.

The Russian position is opaque because it wants to inflict severe economic pain on the West but does not want to be blamed for it. Nevertheless, it seems prudent to anticipate measures calculated to impose severe costs, perhaps in a form totally unexpected by Westerners, as the Western response was unexpected by Putin. Given the market power that Russia has in energy, metals, and grain, Russia has the ability to restrict supply at various critical nodes, causing shortages and price explosions. Nickel, where Russia enjoys an especially commanding market position with 28 percent of world exports, would seem an obvious point of pressure, as restricted supplies would gravely complicate Western plans to electrify auto transportation. The markets for enriched uranium (35 percent of world supply), palladium (24 percent), platinum (16 percent) and neon (40-50 percent from Russia and Ukraine, critical for semiconductors), also look quite vulnerable.

The West’s policy is now to refuse to buy anything from Russia that it doesn’t absolutely need. It is in those sectors, where Russian supply is most needed, that the pressure is most likely to be applied. Wherever the West wishes to carve exceptions is where the pain is most likely to be administered.

As a big producer of energy, grains, and metals, Russia profits from a price explosion in these sectors, the near-death of the ruble notwithstanding. In the past, commodity producers learned to exercise restraint, because if you gouge your customers one year by interrupting supplies and driving up the price, your long-term prospects would be impaired. However, this consideration would seem to have no weight in a situation in which there is no prospect of ever having a long-term relationship again.

The German Problem Revisited

Germany and Russia are now deeply estranged, and this must be figured into estimates of the lengths to which the economic war will go. Both nations invested so much in building a real partnership. Nord Stream II was supposed to be a symbol of their permanent friendship and unbreakable ties. The Germans now find that repugnant. German chancellor Olaf Scholz, in protest against Russia’s war on Ukraine, indefinitely canceled Nord Stream II. Though Scholz objected to an immediate stoppage of Russian energy imports—in recent years Russia supplied 45 percent of the European Union’s (EU) imported gas—he joined in the EU’s pledge to phase out its dependency on Russian gas, oil, and coal imports over time. Germany also promised to invest over $100 billion in new armaments and to create, in effect, a new German Army.

There are lots of good historical reasons why Russia should not want to make Germany a permanent enemy. Over long periods, Europe was always more stable when Germany and Russia had a friendly relationship, invariably in danger of war when they were at loggerheads. Germany, too, was in the past decade a better interlocutor with Moscow than Washington, as good as France. Over several decades, Russia enjoyed an historic friendship with Germany’s Social Democratic Party. Frank-Walter Steinmeier, the eloquent though ineffectual German foreign minister, knew that formula of European stability by heart and taught it to his people. He must be weeping now.

Despite known incentives for friendship, there is an air of finality about the current divide between Germany and Russia, something unbridgeable that can’t be healed by this generation. The Germans have reverted to the idea that the Russians are barbarians and have vitriolically denounced Putin’s war in Ukraine. The Russians think the Germans are pliant tools of Washington and Warsaw. Taking Scholz at face value, there is no possible future in which Germany will be dependent on Russian energy. From the Russian point of view, this is not a mere breakup, but a divorce.

The mutual sundering of ties between Russia and the West, extending even to the barest of cultural exchanges, is a tragedy for the Russian people most of all, but also for civilization in general. By rejecting subjugation to the West, Russia will become servile to China. This will be borne by the Russian masses, bitterly mourned by the intellectuals, and adroitly managed by Putin, but it’s looking these days to be written in stone.

An argument for a moderate policy toward Russia was always that it would give incentives for moderate behavior in return. The Russians would never risk everything for something so paltry as the Baltics. They would never gouge the Germans on gas and forfeit the goodwill of their major customer. They would never do a number of things that would put them under a complete ban. These used to be real restraints for Russia; they have now gone up in smoke.

The New Monetary Disorder

The awful dialectical encounters awaiting us in the metals-energy-agriculture complex will take place under radically novel circumstances: the new monetary disorder created by the seizure of Russian Central Bank assets. This is the H-bomb of economic sanctions, in comparison with which the expulsion from SWIFT is a mere A-bomb. Western authorities, of course, did not expropriate this fund, just froze it. The funds are still there, one supposes, just somewhat inaccessible. Russian capitulations on the issues dividing the parties, it seems, are the terms on which they propose to unfreeze it. Under such circumstances, Russian participation in any commercial transaction with the West becomes extremely problematic, insofar as payment is made via an institution subject to the command of the authorities that just seized its assets. That does not compute.   

The Western central bank sanctions call into question the meaning of money across the East-West divide, because if the money received in exchange for goods can be seized, it’s not really money at all, but money that turns out not to be a legal tender. There can be no transaction with money if the account into which money is placed is itself subject to the frosty treatment, as in, put on ice and made inaccessible to the seller of the goods.

Russia must now endure a future cleaved from Europe. It will seek recovery within the China-led bloc. Its trade in natural resources will almost certainly have preferential aspects, sharply distinguishing between friends and enemies. The United States will try to counter this strategy by threatening to sanction China. Whether America goes all-in on this dangerous gambit is a crucial question for the future. The Biden administration would be tempting fate if it went there, but it seems to be in that line of work, so why not?

Thinking through the consequences, the nature of economic relations between the West and Russia begins to resemble something like barter. We are still in the shadow world, but the logic of events points towards that outcome. In barter-land, as we might imagine it in its pure form, no money exchanges hands. It is no longer recognized as a medium of exchange because experience shows it to be not real. In this new environment, possession is 100 percent of the law, squatters’ rights. As Russia is pushed into fiscal and economic ruin, it will default on every financial obligation to external creditors. As its property is expropriated, it will expropriate and nationalize in turn.

The sudden and brutal divorce signified by the sanctions, including the abolition of contracts, will wrench and contort the world economy and hit Europe the worst—at first. As divorce does generally, it will make both parties poorer and will be cruel and unfair to the little people hurt most. The interdependence that allowed the West to execute such a devastating blow against Russia in the initial phases of this economic war leaves the West and the world acutely vulnerable to very serious retaliatory costs.

The great standoff also intrinsically poses risks to the financial system, whose deepest fear must always be the prospect of defaults. To assess this risk, I proffer a four-step theory for effectuating paroxysms in the world economy: first, abolish all contracts with the most important player in important sectors of the world economy; second, make those sectors be energy, metals, and agriculture, where “globalization” has been especially triumphant; third, have it all go down in an arena comfortable with lots of leverage, magnifying the mutual risk in the event of defaults; and fourth, let the demon loose in sectors where capital returns were poor and investment languished in the past decade. Those seem like sufficient conditions for a great disruption in commodity markets, for a payments crisis that is also a supply chain crisis, and an energy crisis that is also a massive food crisis.

These vulnerabilities exist against the backdrop of the declaration of economic war by one party, and the effectual counter-declaration of the same by the other, which will magnify said fragilities. No one seems to be frightened by this, but I am frightened by it. The financial press and commentariat, by contrast, are positively Pollyannish regarding the “bearable” costs to the “middle class” if the creaking economic mechanism that is the world economy throws a gear. We will assess the consequences later, say the wise men, when they’re irreversible.

David C. Hendrickson is President of the John Quincy Adams Society and the author of Republic in Peril: American Empire and the Liberal Tradition (Oxford, 2018). His website is davidhendrickson.org.