The West’s financial arsenal
Project Syndicate (*)
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 US$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 Zárate 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 Yanukovich 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.
Harold James is Professor of History at Princeton University and a senior fellow at the Centre for International Governance Innovation.