Jerome Powell, Chairman, Board of Governors of the Federal Reserve System testifies before the Senate Banking, Housing, and Urban Affairs Committee. (Photo by Win McNamee/Getty Images)

The West’s self-defeating sanctions

America and its allies are committing geo-political suicide for no discernible gain

Artillery Row

Imagine that you sit down to watch a new film. It is one of your favourite genres: post-apocalyptic survivalism. Shortly after the opening scene wherein the world is demolished by nuclear war, our hero emerges from his bomb shelter. He looks at the devastated world around him and realises that his old life is behind him; he will have to live by his wits from now on. He walks over to his gun cabinet and picks up a shotgun. You think that the action is about to start. 

But then the hero does something strange. He starts acting hysterically, screaming and cursing about his new lot in life. He turns the shotgun toward his own feet and pulls the trigger. After howling in agony, he slings the shotgun over his back and begins to walk painfully toward the outside world, now apparently ready to face the challenges ahead. You turn off the film. The plot is simply too ridiculous to take seriously.

Yet this is what our leaders in the West are doing today. It has become clear in the wake of the invasion of Ukraine that this is about far more than Ukraine. The Chinese response to the invasion has been to increase its economic ties with Russia. The same has been true of countries like Brazil and India. It looks like the BRICs countries are using the invasion as a pretext for re-polarising the world order. From now on, the old American-led unipolar world is no more. Instead, we will be in a world of competing great powers.

Like the hero in the survival film, we are facing enormous new challenges and will need all the wits and resources we can muster. Yet, again like the hero, we seem intent on taking a shotgun to our feet before we embark on this difficult task. We are doing this in the form of the economic sanctions we have imposed on Russia in response to her invasion of Ukraine. The evidence is now overwhelming that these sanctions are far more deleterious for our economies than they are for the Russian economy. They also seem to be catalysing the repolarisation we are facing. In short, they are enormously counterproductive and, in a word, insane. 

Mistaking Moscow for Tehran

The key plank in our sanctions policy is our attempt to wage trade war on Russia. The concept is simple enough: we want to stop sending our goods to Russia, and we also want to stop buying Russian goods. This plan rests on the implicit assumption that Russia needs us more than we need Russia. The promises made for this sanctions policy were quite grand. During a speech in Warsaw in late-March 2022, President Joe Biden said:

The Russian economy was ranked eleventh biggest economy in the world before this invasion. It will soon not even rank among the top twenty.

President Biden is here using a simple US dollar GDP measure. For Russia to fall from eleventh place to outside of the top twenty, the Russian economy would have to contract by almost 55 per cent. Whoever gave President Biden this talking point likely had the Iran sanctions in mind as a template. Between 2012 and 2020, the Iranian economy collapsed by almost 65 per cent. The American foreign policy establishment appears to have believed that this was an apples-to-apples comparison.

Yet even prima facie this comparison was unusual. On a simple US dollar GDP measure, the Iranian economy was ranked the 29th largest in the world in 2012 — a far cry from Russia’s position as the 11th largest today. A closer examination shows that even this under-exaggerates Russia’s size. Economists do not typically use simple US dollar GDP measures to compare countries’ wealth due to the impact of inflation. A more standard metric is called “Purchasing Power Parity GDP” (PPP GDP) which corrects for inflation. On this basis, Russia does not have the eleventh largest economy in the world; it has the sixth largest, close in size to Germany and about 16 per cent larger than the economy of the United Kingdom. For comparison, Iran in 2012 scored eighteenth place on this metric. Thinking the sanctions on Russia would have the same impact as the Iranian sanctions was clearly delusional.

But even these sorts of comparisons — which should be possible for even someone with an undergraduate in economics — are misleading. This is because Russia’s economy is fundamentally different in terms of its structure than the economies it is compared to. Large Western economies have relatively small manufacturing and mining sectors and relatively large service sectors. Consider that the size of the mining sector relative to GDP in the United States and Europe are 2.6 per cent and 2.1 per cent respectively. By contrast, the size of the mining sector in China and Russia relative to GDP are 10.4 per cent and 13.7 per cent respectively. A similar pattern emerges if we look at the size of the manufacturing sectors in these countries. The United States’ manufacturing sector clocks in at 17.4 per cent of GDP while Europe’s is 25.3 per cent of GDP. Russia’s, by contrast, is 30 per cent of GDP while China’s is 36 per cent of GDP.

A Suicidal Trade War

Why is this important? Simply put, Russia makes more of the stuff that is used to make other stuff. Think about this with respect to energy. Russia produces around 40 per cent of Europe’s natural gas, a key commodity used in electricity and heat generation. Can a service sector business remain open without access to this energy? Obviously not. A high street retailer, for example, would not be able to function without electricity. Now put the shoe on the other foot: can an energy provider continue to produce energy if all the high street retailers closed their doors? Of course.

What we are showing here is that all GDP is not created equal. Some output in the economy is more important, more fundamental to how the economy functions than other output. Russia produces far more of this more important output than we do, making it a more critical economy than it appears on a simple GDP metric. How much more important? A simple metric might be to take the PPP GDP of Russia and Germany and adjust them for the size of their mining output. Such a comparison tells us that, on this basis, the Russian economy is 5.4 times (!) as important as Germany when it comes to producing our most basic needs.

These underlying dynamics help to explain what we are seeing as the sanctions bite. Brent oil prices, the core measure of European oil prices, have risen nearly 30 per cent since the invasion. The picture in the natural gas market looks even worse. Since the invasion, European natural gas futures — that is, financial contracts that predict moves in natural gas prices — are up a staggering 120 per cent. This enormous rise in energy prices is one of the primary drivers of inflation, which is currently running at 8.1 per cent in Europe and 9.1 per cent in the United Kingdom.

Food prices are also rising. In the United Kingdom, for example, food prices are rising at 6.7 per cent a year. Some of this is because Russia produces this food directly. For example, Russia produces around 19 per cent of world wheat exports. But some of it is because Russia is a key producer of fertiliser products — more stuff that makes stuff. The latest figures show that Russia is the largest producer of fertiliser products on the planet, accounting for around a fifth of the total market.

Taken together this explains why the sanctions are causing enormous problems in the West. We have rampant, out-of-control inflation. Real purchasing power is falling fast. We are watching ourselves get poorer and poorer with every passing day — and there is a very real risk that we may never regain the wealth that we are haemorrhaging. As the global order is shaken to its core, Western citizens are seeing their high living standards start to evaporate before their eyes due to the irrational sanctions policies. 

If countries do not want to hold US dollar reserves, the party stops

What about Russia? After a short, sharp recession, the Russian economy looks poised to bounce back. The Russian central bank is rapidly slashing interest rates. They can do this because of the remarkable strength of the Russian rouble. In late-March, President Biden tweeted that the Russian rouble had been “reduced to rubble”. Yet, at the time of writing in late-June, the rouble has risen in value against the US dollar by 46 per cent with respect to where it stood before the war. The rouble is now so strong that some Russian policymakers are discussing the possibility of intervening to drive down its price.

The reason for this is simple and well-known: the rouble is a petrocurrency. That means it rises and falls with the price of oil. Oil prices are high due to the sanctions, and these high prices are driving the rouble higher. The sanctions themselves are driving the price of oil upwards; this in turn is driving the rouble skyward.

Russia is becoming richer as we are becoming poorer. 

The worst part of this is that it was perfectly foreseeable. Every competent economist working in financial markets knows that the rouble is a petrocurrency. Any remotely competent energy economist could have told you that the sanctions would drive the price of oil up. 

Mad-capped Misadventures in the Currency Markets

Foreign currency reserves are the money that countries accumulate when they sell more to a given country than they buy from them. Most countries keep these reserves on hand in case of a financial emergency. The US dollar is known as the “world’s reserve currency” and has been, until very recently, the gold standard of reserve currencies.

The reserve currency status of the US dollar is what allows the United States to live beyond its means. Since the 1970s, the United States — and other allied countries like the United Kingdom — have been running up enormous debts with other countries. These debts accumulate because we import more from these countries than we export from them. The balance on the account is settled with currency reserves, which are often recycled into government debt. This arrangement may have led to the waning of our domestic manufacturing sectors, but it has allowed us to spend like drunken sailors. If countries do not want to hold US dollar reserves, the party stops.

Since Russia’s initial incursion into Ukraine in 2014, they have been steadily and deliberately building their dollar reserves. They wanted these ready to go if they ever faced serious economic sanctions. But on 26 February 2022, the United States and its allies did something that was both highly unpredictable and downright insane: they announced that they were seizing Russia’s foreign currency reserves. The move surprised even Russia who, based on their accumulation of the assets in the first place, believed that the US dollar was as good as gold.

Currency reserves are held by countries as an insurance policy. Insurance policies need to be trustworthy. If you think that your insurer is going to run out of money when you approach them for a claim, the policy is useless. What the United States showed the rest of the world on 26 February is that they are unreliable insurers. They communicated clearly to everyone listening that US dollar reserves are only safe if you are undertaking foreign policies that are approved of by the United States.

Any criticism of Western policy was regarded as being pro-Putin

The reaction was swift. On 20 April, one of America’s most reliable allies, Israel, announced that it was dumping some of its US dollar reserves in favour of Chinese yuan. Of course, Israel is a small country, but the fact that a core ally could lose faith so quickly was a damning indictment of the policy. China, on the other hand, is not such a small country. In fact, it is the largest holder of US dollar reserves on the planet. On the 14th of May, Yu Yongding, a former member of the Monetary Policy Committee of the Chinese Central Bank, stated in an online seminar that “geopolitical conflict between China and the United States poses a serious threat to the security of China’s overseas assets, especially its foreign exchange reserves” and that for this reason “China’s overseas asset-liability structure needs to be adjusted”. Translation: it is time for China to start liquidating its dollar holdings.

Although the United Kingdom did seize Russia’s sterling reserves, sterling is a minor reserve currency. What allows Britons to live beyond their means is not sterling per se. Rather, it is the foreign inflows of capital into the City of London. Much of this capital comes from countries with dubious regimes, but the United Kingdom lets it find a home here to float British living standards. A portion of this wealth has historically been Russian. The British government moved to seize this wealth in the wake of the invasion. The effect is the same as the American policy: rich foreigners will now see any assets they hold in London as being subject to geopolitical risks. There is no doubt that there are conversations taking place in London about how best to remove these assets and place them in a safer locale. British living standards will decline accordingly.

Winning the Infowar Against Ourselves

 Why has all of this happened? The consequences of the sanctions were obvious to any thinking economist or financial markets expert the moment they were announced. So, why did our policymakers adopt them? I have no inside information on this to share. But I do have a theory.

In the wake of the invasion, the media response was blistering. Social media ignited with anti-Russian sentiment. The mood was explosive. At the same time, our governments were claiming this showed our prowess when it came to information warfare. Our leaders mocked the Russians for being information war amateurs and said we were showing them how it was done.

No doubt, this information warfare operation was impressive. But as the days and weeks wore on, it became increasingly unclear who it was targeted at. At first, many assumed that it would be targeted at Russians. But it soon became clear that it was instead targeted domestically. It was an inward-looking information warfare operation, presumably designed to keep peoples’ fighting spirit afloat.

I cannot prove it, but I think the environment that this created may have led to the poor policy decisions. In those first few days and weeks any criticism of Western policy was regarded as being pro-Putin. People who questioned whether our policies might be wrongheaded were cast as traitors. One can only imagine the mood this created in our civil service and our decision-making bodies. It likely shuttered dissent and gave rise to a herd mentality. I believe that this is the most obvious explanation for why we undertook the suicidal sanctions policies that we did.

The entire sanctions debate had a very Twitteresque feel to it. Some were even overtly calling to “deplatform” Putin and “cancel” the Russian economy. To anyone attuned to geopolitics and economics this is a childish attitude. But it does appear to have driven the show as the sanctions policies were cobbled together. If this is an accurate assessment, it is not too much of a stretch to say that social media played a large role in the chaotic collapse of the American-led unipolar world order. We will be footing the bill for years to come.

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