The long economic war against Russia: A plan

Beyond financial sanctions: How to cripple the Russian death machine for good.

As the Russian army retreats from the areas around the Ukrainian capital of Kyiv, a series of horrific atrocities are being discovered. 410 bodies have been found so far, littering the ground, often with their hands tied behind their backs. Mutilated children are among them. Here is a report by the BBC:

sophieraworth @sophieraworth

Devastation on the road to Kyiv. Very powerful (and graphic) report by @BowenBBC

This is probably just the tip of the iceberg — more bodies will be found, and Russia still controls plenty of Ukrainian territory in the south and east. From the fact that the Russians brought mobile crematoria and 45,000 body bags to an invasion they thought they were going to easily win, and distributed instructions for the digging of mass graves, it’s clear that mass killings like this were part of the invasion plan from the start. The best guess is that Putin’s intent was to decapitate Ukrainian society by executing political, cultural, and religious leaders — something like what the Nazis and the USSR did to Poland when they teamed up to conquer it in 1939. But there is also plenty of spontaneous cruelty, like mass rapes and slaughter of dogs. It’s the kind of atavistic horror we thought we had left behind in the 20th century, now reborn in the 21st.

That horror should provide the world with another moral moment of clarity. There are no moral gray areas in this struggle — the Ukrainian struggle against Russian power is existential. At the very least, the U.S. and European countries should provide the Ukrainians with any and all of the weapons they need — tanks, rocket launchers, air defense, planes, etc. — to expel the Russians from the rest of Ukraine as quickly as possible, so as to save as many Ukrainian lives as can be saved.

But beyond the physical war — which the Ukrainians are still winning, at least for now — there’s the question of the economic war. Though Russia’s economy is still forecast to shrink by perhaps 10% due to the big financial sanctions that the U.S. and Europe slapped on it in response to the invasion, this is not a catastrophic loss. And more ominously, Putin has managed to stanch the financial bleeding — the ruble has regained almost all of the ground it has lost since the sanctions began:

It’s worth a quick explainer on how why the ruble has recovered. First, Putin has used capital controls to stop Russians moving their money out of the country, much like he did after 2014. Russia has also been using parallel payment systems. But most importantly, Russia is still getting a bunch of foreign exchange from selling oil and gas.

A lot of attention is being paid to the fact that Putin has ordered customers to pay for Russian oil and gas in rubles. This isn’t actually that important. You always had to pay for Russian oil and gas in rubles, because Russian companies use rubles to pay their employees and owners. What’s different now is that because of the Western financial sanctions, Russian banks are unable to swap euros or dollars for rubles, so they’re requiring that customers do the swap for them before payment. In other words, the “pay in rubles” ploy is just a fairly obvious way to circumvent Russian sanctions.

The more fundamental factor here is that the world is still buying a ton of Russian oil and gas. Oil exports have dropped somewhat, but oil is inherently fungible — Russia will simply reroute the tankers elsewhere. And high-ish prices — oil has dropped a bit but is still around $100 — are cushioning that blow. Also, switching away from Russian oil does impose some costs on European economies, so it’s hard to do overnight.

Natural gas is far harder to reroute than oil, since this requires constructing new pipelines to Asia (currently, very few such pipelines exist). But a number of EU countries are very reliant on this gas, most notably Germany, which produces about 15% of its total energy consumption from Russian gas. Naturally they’re squeamish about shutting off the taps instantaneously.

Thus we’re seeing the limitations of financial sanctions. Ultimately, if Russia can keep selling fossil fuels to the world, it can keep getting foreign exchange. So in order to prosecute a long economic war against Russia, we need to look beyond financial sanctions.

I see four basic things the West can do:

1. Export controls

2. Weaning Europe off of Russian gas

3. Draining Russia of smart and competent people

4. Reducing oil prices by switching to electric vehicles

From financial sanctions to export controls

It’s important to recap why the West imposed financial sanctions on Russia — cutting it out of the SWIFT system, freezing the Russian central bank’s overseas funds, and sanctioning Russian banks.

Financial sanctions are mostly indirect sanctions. The main purpose is to make it harder for Russia to buy imported goods. If Russia can’t use the Western financial system, that makes it harder for Russia to get its hands on euros and dollars, and also makes it harder to use the euros and dollars that it has. This makes it harder for Russia to buy things from the West.

And what does Russia buy from the West? High-tech manufactured products — mainly vehicles, machinery, electronics, construction equipment, medical supplies and equipment, and so on. Here, for example, are Russia’s imports from Germany in 2020:

Limiting Russia’s purchases of these goods does several things. First, it makes the Russian people poorer in the short term — for example, by starving them of medicine. Second, it makes the Russian people poorer in the long term, by depriving Russian companies of the parts and components and machinery that they need to produce things for the Russian people.

But making Russians poorer shouldn’t be a top priority for economic warfare. Russian support for the war, and for Putin, has only intensified under the initial shock of sanctions. Meanwhile, our history with Iran, North Korea, and Cuba has shown that impoverishing another country’s people is not an effective way of bringing about regime change.

A much higher priority is starving the Russian military machine of weapons and equipment. As Kamil Galeev notes on Twitter, imported machinery and components are essential to Russian manufacturing:

Kamil Galeev @kamilkazani

Let's discuss Russian economy. Many underestimate its dependency upon technological import. Russia's so deeply integrated into Western technological chains that severing these ties will lead to its collapse. Sanctions are already effective and can be made even more efficient🧵

That includes defense manufacturing. Already, a parts shortage is hurting Russia’s ability to replace the equipment that it’s losing in Ukraine. On March 22, Fortune reported that Uralvagonzavod, Russia’s only domestic manufacturer of advanced tanks, may have run out of parts, and a tractor plant in Chelyabinsk that’s used to repair armored vehicles has also ground to a halt. (Update: Uralvagonzavod has now stopped production entirely, for lack of imported components.)

In other words, when Russia can’t get foreign high-tech parts, components, and machinery, it can’t easily make advanced weaponry. And that means it can’t invade Ukraine or other countries. In addition, though people aren’t really talking about this, high-tech exports are also probably essential to the maintenance of Russia’s nuclear forces, since nukes and missiles turn into duds if they’re not regularly maintained.

Financial sanctions are a very indirect way of starving Russia of technological imports. A better idea is to simply refuse to sell these items to Russia at all. In other words, export controls.

The U.S. has a very advanced system for preventing exports of military goods and so-called “dual-use” goods to countries like North Korea, Iran, and Syria. You can read all about that system here. In fact, you need a very advanced system to enforce export controls, because otherwise third-party countries that aren’t subject to the restrictions can simply buy the products and re-export them to the sanctioned countries. So export controls have to be multilateral, and have to involve punishments for third-party countries and companies that help evade them. Fortunately, the U.S. has spent the past few decades building up just such a system, and is good at catching and blocking those who try to work around it.

In fact, the U.S. is already turning this economic weapon against Russia, and the system is working as designed:

Technology sanctions imposed by the United States and its allies to punish Russia for its invasion of Ukraine have proven far more effective than expected…Thea Rozman Kendler, assistant secretary for export administration, said [that] “compared to the same time period last year, U.S. exports to Russia of items subject to new licensing requirements have decreased by 99 percent by value.”

As the article notes, semiconductor sales restrictions from Taiwan have also had an effect.

This last tidbit showcases an important fact — the more countries participate in the export control regime, the more effective it will be. Obviously Europe, which exports far more high-tech goods to Russia than the U.S. does, will be the biggest player. The EU has to implement export controls that are just as comprehensive as America’s. And Japan and South Korea, which also account for substantial shares of Russian high-tech imports, need to follow suit.

In other words, the entire West — including Japan, South Korea, and Taiwan — has to develop a system for economic warfare. This must be a well-coordinated regime of extremely broad export controls aimed at starving an enemy country of every single thing it could use to make weapons. There are three basic tasks involved in setting up this system:

1. Determining rules for when economic war is to be unleashed (the bar should be high, so the system isn’t deployed frivolously)

2. Harmonization of rules about which exports are to be prohibited, to make sure nothing militarily useful slips through

3. Close cooperation on enforcement

This kind of system promises to be far more effective than traditional “society-punishing” sanctions, or the Magnitsky sanctions aimed at punishing individuals. Without a defense industry, Putin’s ability to threaten his neighbors with the kind of atrocities now being uncovered in Ukraine will be vastly diminished.

Getting off Russian gas

The second component of economic warfare against Russia is the one everyone talks about: Halting European purchases of Russian natural gas. This would help starve Russia of income and foreign exchange, and perhaps more importantly, it would remove a powerful political incentive for European politicians to appease Russia.

Fortunately, a team of German economists has investigated how Germany can go about doing this. Their report, entitled “What if? The Economic Effects for Germany of a Stop of Energy Imports from Russia”, is required reading. Here is a VoxEU summary of their findings, and here is a Twitter thread by one of the authors.

The most important finding here is that a cutoff of Russian energy imports (both oil and gas) wouldn’t be that severe. From the VoxEU article:

To construct a plausible size for the shock to the German economy, we make the assumption that the result of a Russian energy embargo will be a reduction of gas deliveries of 30%, or about 8% of total German energy consumption…What would be the economic effects?…

In [our] estimated model, for low elasticities of substitution, the…model predicts modest losses equivalent to 0.2–0.3% of German GDP…In a last scenario where we model a more extreme 30% adjustment in gas usage, the economic losses rise to 2.2% of GDP[.]

So basically, the worst-case scenario here is a 2.2% decline in German GDP in the short term. Limiting this shock may involve expansionary monetary and fiscal policy, if the hit to German energy supplies causes a loss of economic confidence that sparks a recession.

The authors also have a series of recommendations for how to cushion the impact of the cutoff. Most importantly, they advise doing the cutoff early, so that the summer months — when gas demand is low because there’s little need for heating — can be used to make the adjustment to other energy sources. They also recommend common-sense things like building out energy infrastructure and giving financial support to low-income households, as well as some technical measures like adjustments to insurance policies.

Ben Moll, one of the authors, also has a great supplement citing some historical examples of how countries shifted production rapidly in response to national security threats. These include Japan’s response to China’s rare earth embargo in 2010, the shutdown of a contaminated Russian oil pipeline in 2019, face mask manufacturing in the Covid pandemic, the move away from single-use plastic, and more. Here’s a Twitter thread he wrote about it:

Ben Moll @ben_moll

In our import stop paper we emphasize that it makes a big difference how much people and firms can substitute for Russian energy inputs. How might such substitution work in concrete terms? A new supplement to our paper has some more thoughts benjaminmoll.com/RussianGas_Sub… Thread:

Moritz Kuhn @kuhnmo

"What are the macroeconomic & distributional consequences for Germany of a stop of Russian energy imports?" Our @ECONtribute policy brief provides an answer @BachmannRudi @DBaqaee @christianbaye13 @kuhnmo @andreasloeschel @ben_moll @APeichl #KarenPittel @MSchularick https://t.co/V5jwmSHsqm

It seems very likely that what works for Germany will also work for other European countries that buy Russian oil and gas. Yes, there’s going to be a bit of economic pain, but this is the inevitable result of decades of complacency in which European countries allowed themselves to become dependent on Russian hydrocarbons.

But the pain won’t be that bad, thanks to technology. The remarkable advances in solar and wind power over the last few decades mean that shifting away from Russian fuel will be a lot cheaper than it would otherwise have been. (I’ll write more about the specifics of this shift in a later post.) Between renewables, nuclear, and imported LNG, there are plenty of alternatives to paying billions of dollars to Vladimir Putin.

Brain drain

Under normal circumstances, “brain drain” isn’t a problem. When countries like the U.S. take in high-skilled immigrants from countries like India, those immigrants often contribute to their old countries with investment and a flow of technological ideas, sometimes even moving back to start businesses or teach what they know. The opportunity of immigrating to the U.S. also encourages more people to get a technical education in their home countries, which ends up boosting the supply of skilled workers in those countries as well. It’s really a win-win situation.

The economic war against Russia is NOT normal circumstances. Although Putin has majority support for his war, many educated Russians — especially young educated Russians — want no part of the repressive, fascist state that Putin is creating. Tens of thousands have fled the country, and this might become hundreds of thousands. These are disproportionately likely to be the kind of people Russia needs to keep its war machine going — engineers, technicians, and skilled managers.

The U.S., Europe, and other countries should be making active efforts to take in every one of these people — permanently — through the asylum system. This will encourage even more talented Russians to flee. Unlike with high-skilled immigration between friendly countries, this will cause a major brain-drain. These Russian expatriates will not send money or technological know-how back to Russia, or return there to build private businesses and enrich the nation. Instead, Russia will be simply be deprived of needed skills to sustain its high-tech weapons programs.

Electric cars for the long term

You’ll notice that there’s one factor I haven’t mentioned yet: China.

While it’s not clear whether China actually supports Putin’s invasion, it has definitely been unwilling to join in any sanctions regime to cripple its most important ally. In the short term, this will strengthen Putin’s hand by providing him a market for Russian oil. In the long term, gas will follow, after Russia constructs more pipelines across Siberia. And even more crucially, China will be able to help Russia sustain and/or rebuild its defense industries, by providing the parts and machinery that Russia traditionally bought from Europe. If you look at what Russia imports from China, it includes quite a lot of machinery and electronics:

This shift will take years, of course. But it will eventually happen. A well-integrated China-Russia economic bloc will be quite a formidable foe, since Russia’s natural resources and China’s technical and manufacturing prowess complement each other nicely.

But one thing Western countries can definitely do to hurt Russia’s economy in the long term — and thus hurt its defense industries — is to shift to electric vehicles. Road transportation is responsible for about half of global oil demand, so when the world shifts to EVs, oil is going to be a much less valuable commodity. That shift will weaken Russia permanently, so it’s incumbent on the U.S. and Europe to move it along as fast as possible.

Fortunately, the shift is well underway. Electric vehicles are making inroads into the market at a rapid pace:

Nat Bullard @NatBullard

My chart of the day: *Auto sales peaked in 2017 *Electric vehicle sales keep increasing *EVs are, therefore 100%+ of sector growth, and have been for years

The pricing mechanism is firmly on the side of EVs here — sustained high oil prices, including any increases from sanctions and the war, will drive more rapid adoption of electrics. Furthermore, legislators in the U.S. have been pushing forward a number of measures to speed up EV adoption, including funds for building out networks of charging stations.

The economic war against Russia makes this effort even more urgent. In addition to building infrastructure, the U.S. government should incentivize people to turn in their old internal combustion cars for new electrics — a sort of “cash for clunkers” program, but for EVs only. Mass production of EVs will decrease the price even more, via learning curves, which in turn will accelerate adoption even more. Even China will have no choice but to switch to EVs, even though that will hurt Russia.

Another challenge is securing the resources to build all these EVs. Demand for lithium, nickel, cobalt, manganese, copper and other minerals are likely to soar. The U.S. and its allies need to make deals with all the countries where these minerals are located, to ensure supplies will be available. We should also be pouring research money into finding better kinds of batteries that use minerals that are in more plentiful supply.

If we can tip the balance decisively toward EVs before China can reconstitute Russia’s defense industries, we can make sure that Russia’s hydrocarbon-funded war machine never gets fully back on its feet. Every tank, every rocket launcher, every plane that Russia fails to produce is one less death machine to cause the kind of mass horror now being uncovered in the fields of Ukraine.

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