Initially, Europe shamefully agonized over how it should respond to the Ukrainian crisis. Now, the EU – and especially Germany – seems to be coming full circle and embarking on a level of both sanctions and combativeness that was hard to imagine just a few days ago. This shift has probably been bolstered by Ukraine’s show of force on the ground and the impeccable leadership of President Volodymyr Zelensky, as well as by Russia’s apparent failing blitzkrieg and substantial domestic resistance to the war.
Below, I break down the effectiveness of the EU’s various levels of policy intervention as well as their likely effect and consequences.
Sanctions: The International Monetary System Always Trumps the Payments System
SWIFT Exclusion Is Useless If Not Complete
On the sanctions front, it was incredible to observe how political attention focused so quickly on SWIFT. Somehow, in the eyes of non-experts, SWIFT became the most powerful and politically expedient way to cut Russia’s banking system off from the international financial system. But as my friend Zoltan Poszar puts it, the international payment system is just international supply chains in reverse. It is not possible to cut Russia off from the international payment system unless one is prepared to cut it off from global supply chains – for example, from energy supplies to Europe.
Net natural gas importers are well aware of this fundamental tension, which is why they were initially not prepared to cut Russia off from SWIFT. Yet they eventually caved in to agree to a “targeted and functional” SWIFT exclusion whose carve-outs defeat the whole point of the exclusion.
Indeed, if Sberbank, a state-owned bank that is Russia’s largest, is barred from SWIFT and cannot make transactions in dollars with foreign counterparties while a Moscow bank can take the payment and then net it out with Sberbank, the SWIFT exclusion is useless. This is why even the GL-8 exclusion from the first batch of US sanctions that banned dollar transactions – theoretically far more powerful than SWIFT – remain toothless if all energy transactions are exempted as clearly outlined by Adam Tooze.
Freezing Central Bank Assets Is the Financial Equivalent of a Nuclear Weapon
With the decision to freeze the assets of the Central Bank of the Russian Federation (CBR), the United States and European Union have effectively cut Russia off from the international financial system. They have entirely crippled Russia’s ability to use its foreign exchange reserve to fend off sanctions.
The CBR holds nearly $630 billion worth of reserves, which were accumulated as a war chest precisely to be able to endure trade and financial sanctions of the sort imposed in 2014 to 2015. But the current sanctions are of an entirely different order of magnitude. Essentially, they neutralize a large part of the reserves held by Russia because most of them are held in the form of securities, deposits, and gold assets that are custodied abroad and used by way of investment banks that serve as agents of the CBR. If these assets cannot be used, they severely undermine the CBR’s ability to stabilize its exchange rate and meet its international payment obligations. The determining factor is the share of these deposits that are effectively under the reach of the current sanctions.
The current situation is reminiscent of the weeks leading up to France’s 1940 defeat by Nazi Germany. Then, the Banque de France and the French Navy made heroic efforts to evacuate the Banque de France’s gold reserves precisely to preserve France’s ability to fight the war. Russia is learning the hard way that the fiat money used in our current Bretton Woods II system presents a similarly grave threat. [Fiat money – including most modern paper currencies such as the US dollar – is government-issued currency that is not backed by a commodity such as gold.]
The effectiveness of these sanctions will, however, depend on three critical factors:
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Their actual implementation and the degree to which Russia will be able to mobilize reserve assets held in more friendly jurisdictions such as China;
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The legal battle that will ensue, which could eventually force the freeze to be relaxed; and
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The flow of fresh hard currency proceeds from gas and oil sales, which currently run at some $20 billion per month according to Robin Brooks. This flow wholly depends on the EU’s ability to ration gas in Europe – a topic that has yet to be widely discussed.
If the current set of sanctions are properly implemented, their importance would be difficult to underestimate. Indeed, these sanctions could provoke a domestic financial crisis that could bring Russia to its knees in the following way:
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The Central Bank of the Russian Federation (CBR) tries to protect both its fire power and the Russian Rubel (RUB) by holding a fire sale of RUB for hard currency that will probably drive the RUB to levels not seen since the late 1990s.
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Hard currency shortages lead to a nationwide run on banks that could quickly become systemic and result in a complete collapse of the banking system and credit creation.
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This collapse provokes debt monetization and a sharp rise in inflation for all imports – particularly those from the West such as luxury goods and tech. These will quickly become unavailable to ordinary Russians.
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Such unavailability affects the world economy through several channels: a complete stop in Russian imports, a stop in Russian foreign direct investment abroad, and, even more importantly, a series of defaults on international Russian debt. European banks are particularly exposed.
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These events undoubtedly lead to a multiyear recession that is deeper and more broadly based than the one experienced in 2014.
A German Revolution Under Way
The extraordinary session of the German Bundestag that took place on February 27, 2022, was nothing short of revolutionary. The fact it took place under the leadership of a chancellor from Germany’s social democratic party (SPD) is all the more striking. That the policies that were announced in that session seem to be met by both popular support – at least 100,000 people took to the streets of Berlin that day to protest Russia’s invasion – and consensus among all of Germany’s mainstream political parties makes it profound.
Russia’s network of influence, collusion, and corruption that it patiently built in Western Europe over President Vladimir Putin’s 25-year reign seems to be collapsing right before our eyes in a matter of days. It is this collapse that is causing Moscow to shiver and that likely provoked Putin’s raising the nuclear trump card.
Indeed, Germany broke nearly every one of its security policy taboos this past weekend:
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It armed Ukraine with possibly around 500 stingers missiles and 1,000 heavy anti-tank rockets. This step requires the active participation of Poland, France, and other allies and is probably the best possible starting point for building Europe’s strategic autonomy. Moreover, the EU announced that it will pay for Ukraine weaponry, suggesting that additional pooling of resources is underway to which Germany will certainly be a major contributor.
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Germany is prepared to entirely overhaul its military and spend €100 billion on it in 2022. This move seemed wholly implausible just a week ago and, even though it might be operationally impossible to spend so much in so little time, it marks a new degree of political responsibility.
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Germany agreed to spending 2 percent of its GDP on defense as per NATO commitments, and it will place German troops in Eastern Europe with a political mandate to defend “every inch of NATO territory.”
All in all, it is still somewhat unclear whether these moves by Germany will spur a rebuilding of NATO or they are a first step toward a genuinely European defense. In any case, a conversation initiated by French President Emmanuel Macron a couple of years ago that had led nowhere is now right at the center of Europe’s political agenda.
It is notable that, for the first time, Europe will also support Ukraine militarily. This is not only a symbolic precedent, but it will also have a significant impact given the €500 million committed so far. These funds will be implemented through the EU’s Peace Facility, a new institution enacted just a year ago.
European Consequences: Another Leap Induced by Crisis
A Fiscal Tide That Lifts All Boats
The European Commission had prepared a communication on the reintroduction of Europe’s fiscal rules that was meant to be announced this week. Given the profound changes to the fiscal outlook that this announcement would have made, it is near certain that it will now be shelved.
Since Germany announced its golden rule for defense spending, it will be hard for it to avoid establishing a golden rule for climate spending. The sum of these could change Europe’s fiscal stance quite radically starting this year and over the medium term.
Germany’s fiscal stance, which only became modestly more accommodative because of the coalition agreement of its current leadership, will become sharply expansionary. It is also quite probable that the spending necessary to withstand possible disruptions in natural gas supplies are not yet budgeted and could be substantial. At this point, the almost inevitable fix for the short term will be for Germany – this year – to reverse its decision to close all its nuclear power plants. I would not be surprised if they are kept running throughout this legislative period and if Germany considers building new ones by the end of it. The central question in the short term, however, is the supply of natural gas, which remains Putin’s critical leverage and source of revenue to finance Russia’s war effort.
It is hard to conceive of Europe being successful in its strategy unless it cuts gas and oil imports very soon. This would require taking over Gazprom’s 12 storage facilities in Europe and force the rationing of consumption, the switch to coal and nuclear power plants, and the more intense use of facilities for liquefied natural gas (LNG). Although this conversation has not really started, it is critical to address the political and financial leverage Russia holds over the EU.
Monetary Policy Must Follow
Against the backdrop of this somewhat revolutionary set of decisions, it is striking that the European Central Bank (ECB) seems to be sticking to a fairly conservative view. Speeches by board members in the coming days are going to be critical. One by Isabel Schnabel on February 24, 2022, is probably already outdated, but it had opened the sequencing of the normalization process to question – only to subsequently close it again by suggesting that the reinvestment policy of both the ECB’s Asset Purchase Program (APP) and Pandemic Emergency Purchase Program (PEPP) offered enough flexibility.
The ECB needs to show immediately that it is ready to accompany the bold fiscal commitments that are being made at present and fulfill its secondary mandate to support the general policy of the EU. A national central bank hiding behind its inflation mandate in a situation of war would be (and should be) stripped of its independence.
The ECB should not take bolder steps because it has changed its view of the macroeconomic outlook; rather, it must do so because the current financial conflict will necessarily result in great financial strains for the European banking system. While the total exposure of European banks to Russia is relatively small, it is concentrated in a few banks, creating potential financial stability risks that must be addressed by the ECB.
Conclusion
Europe’s failure to agree to SWIFT sanctions without the exclusions that made them useless has forced a far stronger policy response in the form of an asset freeze of Russia’s central bank. This creates a major break in the international monetary order created by Bretton Woods II. Central bank reserves are now worth as much as the dominant reserve currencies issuing them want. This could have profound long-term consequences.
Europe’s decision to arm Ukraine and to arm itself is a tectonic shift that ought to provoke others. Yet neither this nor any of the other revolutionary steps that have been taken recently are worth anything if the EU cannot rapidly free itself of Russia’s oil and gas imports. This will require heroic efforts.
