Monday, October 20, 2014
10

The West’s Financial Arsenal

PRINCETON – The revolution in Ukraine and Russia’s illegal annexation of Crimea have generated a serious security crisis in Europe. But, with Western leaders testing a new kind of financial warfare, the situation could become even more dangerous.

A democratic, stable, and prosperous Ukraine would be a constant irritant – and rebuke – to President Vladimir Putin’s autocratic and economically sclerotic Russian Federation. In order to prevent such an outcome, Putin is trying to destabilize Ukraine, by seizing Crimea and fomenting ethnic conflict in the eastern part of the country.

At the same time, Putin is attempting to boost Russia’s appeal by doubling Crimeans’ pensions, boosting the salaries of the region’s 200,000 civil servants, and constructing large, Sochi-style infrastructure, including a $3 billion bridge across the Kerch Strait. This strategy’s long-term sustainability is dubious, owing to the strain that it will put on Russia’s public finances. But it will nonetheless serve Putin’s goal of projecting Russia’s influence.

For their part, the European Union and the United States have no desire for military intervention to defend Ukraine’s sovereignty and territorial integrity. But verbal protests alone would make the West look ridiculous and ineffective to the rest of the international community, ultimately giving rise to further – and increasingly far-ranging – security challenges. This leaves Western powers with one option: to launch a financial war against Russia.

As the former US Treasury official Juan Zarate revealed in his recent memoir Treasury’s War, the US spent the decade after the September 11, 2001, terrorist attacks developing a new set of financial weapons to use against America’s enemies – first Al Qaeda, then North Korea and Iran, and now Russia. These weapons included asset freezes and blocking rogue banks’ access to international finance.

When the Ukrainian revolution began, the Russian banking system was already over-extended and vulnerable. But the situation became much worse with the toppling of Ukrainian President Viktor Yanukovych and the annexation of Crimea, which triggered a stock-market panic that weakened the Russian economy considerably and depleted the assets of Russia’s powerful oligarchs.

In a crony capitalist system, threatening the governing elite’s wealth rapidly erodes loyalty to the regime. For the corrupt elite, there is a tipping point beyond which the opposition provides better protection for their wealth and power – a point that was reached in Ukraine as the Maidan protests gathered momentum.

Putin’s public speeches reveal his conviction that the EU and the US cannot possibly be serious about their financial war, which, in his view, would ultimately hurt their highly complex and interconnected financial markets more than Russia’s relatively isolated financial system. After all, the link between financial integration and vulnerability was the main lesson of the crisis that followed the US investment bank Lehman Brothers’ collapse in 2008.

In fact, Lehman was a small institution compared to the Austrian, French, and German banks that have become highly exposed to Russia’s financial system through the practice of using deposits from Russian companies and individuals to lend to Russian borrowers. Given this, a Russian asset freeze could be catastrophic for European – indeed, global – financial markets.

Putin’s plan for destabilizing Ukraine is thus two-pronged: capitalize on linguistic or national animosities in Ukraine to foster social fragmentation, while taking advantage of Western – especially European – financial vulnerabilities. Indeed, Putin sometimes likes to frame it as a contest pitting him against the power of financial markets.

The arms race that preceded World War I was accompanied by exactly the same mixture of military reluctance and eagerness to experiment with the power of markets. In 1911, the leading textbook on the German financial system, by the veteran banker Jacob Riesser, warned that, “The enemy, however, may endeavor to aggravate a panic…by the sudden collection of outstanding claims, by an unlimited sale of our home securities, and by other attempts to deprive Germany of gold. Attempts may also be made to dislocate our capital, bill, and securities markets, and to menace the basis of our system of credit and payments.”

Politicians began to grasp the potential consequences of financial vulnerability only in 1907, when they faced a financial panic that originated in the US but that had serious consequences for continental Europe (and, in some ways, prefigured the Great Depression). That experience taught every country to make its own financial system more resilient to ward off potential attacks, and that attacks could be a devastating response to diplomatic pressure.

That is exactly what happened in 1911, when a dispute over control of Morocco spurred France to organize the withdrawal of DM200 million invested in Germany. But Germany was prepared and managed to ward off the attack. Indeed, German bankers proudly noted that the crisis of confidence hit the Paris market much harder than markets in Berlin or Hamburg.

Countries’ efforts to protect their financial systems often centered on increased banking supervision and, in many cases, enlarging the central bank’s authority to include the provision of emergency liquidity to domestic institutions. Subsequent debates about financial reform in the US reflected this imperative, with some of the US Federal Reserve’s founders pointing out the military and financial applications of the term “reserve.”

At that time, financial-reform efforts were driven by the notion that building up financial buffers would make the world safe. But this belief fueled excessive confidence among those responsible for the reforms, preventing them from anticipating that military measures would soon be needed to protect the economy. Instead of being an alternative to war, the financial arms race made war more likely – as it may well be doing with Russia today.

Read more from "The Great War Revisited"

Hide Comments Hide Comments Read Comments (10)

Please login or register to post a comment

  1. CommentedDavid Donovan

    Economic sanctions against Russia would not have a huge impact in the US, yet they could potentially have a large negative impact on Europe

  2. CommentedSpiro V

    Strain on Russia's public finances? With a debt to GDP ratio of 10%, US and Western European countries can only wish they had such low debt. The USA has debt to GDP of over 100%, and their situation can only get worse with a trade and financial restrictions.

  3. CommentedJoe Zammit-Lucia

    "In a crony capitalist system, threatening the governing elite’s wealth rapidly erodes loyalty to the regime. For the corrupt elite, there is a tipping point beyond which the opposition provides better protection for their wealth and power."

    Quite right. But one has to wonder whether there is a substantive difference in this regard between Putin's crony capitalism and the crony capitalism that is leading major German, British, Italian, French and other European corporations to lobby hard against a trade war with Russia. We're all implicated at, at some level, all systems share similarities in terms of "corruption" and state capture by powerful financial interests.

  4. Commentedj. von Hettlingen

    "The West financial arsenal" that Mr. James describes, is in fact stored in an ornate, grey building close to the White House in Washington - the Treasury Department. Immediately after the 9/11 attacks in 2001, the US has been "developing a new set of financial weapons to use against America’s enemies – first Al Qaeda, then North Korea and Iran, and now Russia".
    Mr. James sees, since the annexation of Crimea, "Western leaders testing a new kind of financial warfare". New, but the expansion of sanctions against Russia may not have the same effect as they had in previous cases.
    The financial war against Iran waged in 2007 was part of the US efforts to prevent Tehran from acquiring nuclear weapons. There were formal financial sanctions on Iran, as agreed at the UN. They prohibited transactions with Iranian banks, companies and individuals said to be directly involved in the country's nuclear programme. They were limited in scope, so that even Iran's allies, China and Russia, were willing to accept. The more powerful move involved US officials travelling the world persuading banks and companies to voluntarily abandon their business with Iran. This aimed to enhance a psychological impact of dealings with Iran, as these institutions would be subjected to greater scrutiny, making it difficult for them to operate in the US, if they alienated Washington.
    Yet when it comes to Russia, The US faces a problem at the UN, due to Russia's veto power. But would it be hurt by America's financial squeeze? The key to Russia's prosperity is its oil and gas sector. Russia is a petro-power. It has vast quantities of oil reserves and untapped natural gas. It also needs energy investment. So another way to strangle Russia's economy would be to hit its vulnerable oil and gas industries. It had worked with Iran and forced Tehran to go to the negotiating table with the P5+1.
    Economic sanctions against Russia would not have a huge impact in the US, yet they could potentially have a large negative impact on Europe. Over half of Russia's revenues come from gas and oil to the EU, and around 25% of gas consumed in the EU are imported from Russia.
    In light of the intertwined economies, sanctions could cause the Russian economy to contract, and may have serious implications for the whole of Europe, and indirectly for global financial markets. Therefore the EU and the US are keen to pursue diplomacy, and are unlikely to get to the point where they impose a full economic embargo.
    The only people who could inflict pain on Putin are his cronies and the oligarchs, as their economic interests will be targeted. Russia's economy is already struggling. Last year it saw GDP growth of just 1.3%, and the economy ministry has warned of stagnation amid rising inflation. Moreover it is seeing a capital flight - some $65-70 bn are said to have already left the country in the last three months, compared to $63bn for the whole of last year. With the EU prepared to take more serious steps to respond to the crisis, Russia may just be celebrating its Pyhrric victory over Ukraine.

  5. CommentedJohn McDonald

    Right. And to reiterate the last point: If the West declares financial "war" on Russia, we can only expect them to respond in the best way they can - with further military adventures.

  6. CommentedJean-Louis Piel

    so right: "A democratic, stable, and prosperous Ukraine would be a constant irritant – and rebuke – to President Vladimir Putin’s autocratic and economically sclerotic Russian Federation. In order to prevent such an outcome, Putin is trying to destabilize Ukraine, by seizing Crimea and fomenting ethnic conflict in the eastern part of the country."

    And also : "In a crony capitalist system, threatening the governing elite’s wealth rapidly erodes loyalty to the regime. For the corrupt elite, there is a tipping point beyond which the opposition provides better protection for their wealth and power – a point that was reached in Ukraine as the Maidan protests gathered momentum."

    Very brilliant article with this comparison of 1900-1914 events.

    I agree with this conlusion : "military measures would soon be needed to protect the economy. Instead of being an alternative to war, the financial arms race made war more likely – as it may well be doing with Russia today."

    But with this comment : it is necessary to understand that this Russia has started this war - in fact since 2,000-2004. And we, the West, with our Asian Allies ( Japan, South Korea, Taiwan) and friends ( China), we will have to fight - this war will end with our victory.

    It is important to define what terms are defining our victory.

    The most likely is that Russia is becoming a Chinese province - in the 20 years to come.

    The worst is to end with a nuclear war which will erase these 110 millions ethnic Russians from the surface on Earth and probably some parts of the Western World. But not China, not India, not Africa, not South American countries, not East and South Asian countries. Then the World in this worst case scenario will survive quite well.

    A war couldn't be only "financial" - when a gun is put on our head , we need to fight militarily.

    In the beginning of WWI (1914) and of WWII (1939) USA was very very weak militarily. But in less than 18 months it becomes very strong. It will be the same for European countries. Both USA, Canada and EU will be invincible in a war against this Russia.
    Russia has no ally - not even China. China will never fight against the West for the sake of Russia. The Chinese hate the Russians. They have in mind what happens with Russia between 1830 and 2000 .They play the Russians as a cat play with a mouse. The name Russia - "a dying Empire" and Putin " a mad dog". In both case they are right.

  7. CommentedAfonso Eans

    I wonder what Prof. james means with a democratic Ukraine. One with Svodoba and Pravyi Sektor in Power?

      CommentedTrevor Bacon

      Yes Afonso, One can only wonder. Added to that the picture of a a prosperous Ukraine after the Chicago boys have done their magic. Is that prosperous Ukraine as in everything being sold at cents on the dollar while the people sink into international corporate serfdom. I have to say that I read the first lines of the the first few paragraphs I thought he was just giving examples of the riotous propaganda that is circulating at the moment. Then to my horror I realised the guy actually meant it. Really, its a shock to realise that such intelligent people believe such rot.

  8. CommentedStephen Pain

    I think that Putin can afford to build the bridge - 60 Billion US dollars left with the ex-President of the Ukraine. If you look at the suspension bridge in Vladivostok that cost 1.5 or so billion. So the building of Kerch bridge is peanuts. Indeed the money taken from the Ukraine can pay for all the operations. On top of this all the resources taken from the Crimea can pay for that invasion. Also when the Russians double the cost of gas, they can cover any additional costs. I think that Putin is a very shrewd entrepreneur of the organized kind - he is also very good at projecting being a man of the people, even though he and his colleagues in the FSB and former KGB have with the oligarchs their friends, own a vast part of the Russian economy. I am sure that he will not rock the boat too much, because all those who keep him in power might not like a credit crunch. He is very vulnerable - like Stalin he is a "man of steel" - any chink in the armour will be exploited - any health concern magnified. What we see in this foray into expansionism might signal something happening to his power base. Even though popular now, the Russian people will not like to see their economy and their income decline. I certainly think it is time that diplomats and historians factored in their analyses the reality of what Russia is today. It is dangerous, because it is ultimately a political tinderbox after the fall of the Soviet Union. I wonder why he has gambled so much. To take risks like this. Something is going on in Moscow - and that is what we should find out. Indeed for now, it is in the interest of everyone that Putin is appeased - a compromise reached. A Russia without Putin would be at the moment a disaster. I myself believe the biggest mistake ever made in recent history was the West's pressure on the Soviet Union to implode - and with it went the hope for a pragmatic and structured, progressive transition in which Gorbachev could have led the country to real prosperty and peace. What followed was a debacle.

Featured