Why sanctions may backfire

Immediately after Russian troops attacked Ukraine in February 2022, a group of Western countries – including the U.S., EU states, Australia, Great Britain and Japan – imposed tough sanctions against Russia. French Economy Minister Bruno Le Maire announced on March 1, 2022, that the West would wage “an all-out economic and financial war against Russia.” However, even after more than nine months, the sanctioned state, Russia, shows only moderate signs of economic weakening. On the contrary, revenues from oil exports have amounted to about $20 billion per month until mid-2022, a significant increase of about one-third from $14.5 billion per month in 2021. Not only can the Russian government continue the war of aggression, but it is also liquid enough to manage without exporting gas to Western Europe.

At the same time, the consequences of Russia’s retaliatory sanctions are being painfully felt in many countries of the European Union, as well as in developing and emerging economies. If only in the interest of their own populations, it would be imperative to lift the economic sanctions against Russia. More importantly, the politicization of international economic relations is a dangerous error that will lead to a continued weakening of the international division of labor.

The sanctions were imposed to punish Russia’s attack. Needless to stress that there is no justification for the invasion in international law. Many people were and continue to be shocked that war has returned to Europe. The punishment of the Russian government and society continues to find much support in European countries. Australia, Canada, Japan and the USA have supported the sanctions regime. Critics of the sanctions are always asked whether standing idly by is an alternative. There is little discussion, however, about whether economic sanctions are a wise policy. The question of what happens if the sanctioned state does not end its war of aggression was and is given little space in the debates. This is negligent, because the sanctions are having an effect, albeit quite different from what the sanctions advocates expected.

The sanctions alliance has either misjudged or failed to consider at least three dimensions of its actions. The first concerns the ability of Russian society to cope with sanctions. To put it bluntly: People in Russia know sanctions and know how to live with them. The second point concerns the consequences of sanctions for the international financial system: The measures can lead to the emergence of competing systems, thus further fragmenting international finance. Thirdly, the sanctions have consequences for international trade and are likely to exacerbate the already observable trend toward the rollback of international economic relations.

Economic sanctions have of course been implemented before. More than 100 years ago, after the end of the First World War, the post-Tsarist Russia was immediately confronted with economic sanctions by the Western Allies in October 1919. Bolshevism was to be defeated through the application of sanctions. The project failed and laid the foundation for a critical perception of the actions of Western countries against Russia. Vladimir Putin can build on that experience of Russian society.

The debate on sanctions in Germany, France and Great Britain at that time was remarkable. German Foreign Minister Herrmann Müller (SPD) opposed Germany’s participation in sanctions against the USSR because they would strengthen, not weaken, Bolshevism. Müller referred to the experience of Germany in World War I, which suffered the starvation deaths of up to 800,000 people, most of them civilians, because of the British blockade of sea routes to Germany, a violation of international law. In France, prominent intellectuals and publicists called the USSR blockade a great crime. In Britain, E.D. Morel writing in Foreign Affairs in 1920 castigated economic sanctions as a “cruel, bestial, calculated, cowardly, and on balance diabolical method of destroying human life”.  Then as today, the British government declared that it is “not at war with the Russian people, or with any section of the Russian people”.

Until its collapse, the USSR was repeatedly confronted with economic sanctions, such as limited access to state-of-the-art technology. Against the backdrop of these experiences, Russian society may have developed a level of improvisational skill and capacity for suffering that clearly exceeds that of Western societies. According to the Washington Post, Russian Defense Minister Sergei Shoigu told the British government in February 2022 that “Russians could suffer like no one else”.

With respect to Russian society’s perception of the sanctions, the sanctions proponents made another mistake. This concerns the perception of the U.S., but also of Western Europe, as peacebuilding actors. That perception enjoys only moderate support in Russia and other non-Western countries. It is worthwhile in this context to read a series of lectures by the British historian Arnold Toynbee from 1952 entitled “The World and the West.” Outside of Western countries, Toynbee suggests that the West had been perceived primarily as aggressors and less as peaceful players. Toynbee’s assessment 70 years ago is consistent with today’s perception of the sanctions alliance in many non-Western countries and explains why in 2022 it is not possible to find a large number of supporters of the sanctions against Russia in developing and emerging countries. India, as well as almost all countries in Africa and South America, are maintaining or even expanding their economic relations with Russia. In December 2022, the Indian government is adamant that it will continue to important oil and weapons from Russia despite efforts of Western governments to reduce commercial transactions.

A second point concerns the consequences of the sanctions for the financial markets. The freezing of Russian claims and the exclusion of Russian banks from SWIFT, the Belgian-based service provider for the processing of cross-border payments, primarily affect the West itself. The confidence of non-Western countries in the reliability of cross-border transactions is being shaken. The form and extent of the financial sanctions are new. During the Crimean War (1853-1856), for example, Her Majesty’s Chancellor of the Exchequer unapologetically settled claims of czarist Russia. A British minister remarked that, of course, even in wartime the claims of the enemy had to be met.

The question, then, is whether today’s inclusion of the financial sector in the sanctions is smart policy or whether earlier approaches are more convincing. Certainly, financial sanctions have been imposed on smaller economies time and again, but Russia is a large economy which held substantial reserves abroad. So what are the consequences of financial sanctions in the medium term?

For starters, they are spurring the search for alternatives. CIPS, SWIFT’s Chinese competitor, saw a sharp increase in transactions from May to July 2022. The longer sanctions are imposed, the more non-Western countries will find ways to process payments outside the Western financial system. The sanctions alliance undermines the foundation of the international division of labor and thus harms itself in the long run. Without a functioning financial system free of political interference, the emergence of an economic Iron Curtain (as former U.S. Treasury Secretary Hank Paulson put it back in 2018) will increase in an era of ongoing geopolitical tensions. The seizure of state and private assets by the governments of the sanctions alliance could stimulate comparable actions in the People’s Republic of China, for example.

A second effect of financial sanctions is that currency reserves become less attractive. There is a latent risk that these foreign currency claims will be seized. Ironically, the globally observed increase in foreign exchange reserves is itself the result of inadequate structures. When the countries of Southeast and East Asia were caught in the maelstrom of the Asian financial crisis 25 years ago and were on the verge of bankruptcy, the U.S.-influenced International Monetary Fund failed. Its crisis management worsened the situation. The lesson learned by many countries was to strengthen their own resources by building up high foreign exchange reserves. South Korea, for example, has increased its foreign exchange reserves by more than 700 percent since 1998, China by 2,100 percent and Russia by more than 4,800 percent.

From the perspective of OECD countries, this was useful because foreign exchange reserves are mostly held in the form of highly liquid government bonds. The capital flows from South Korea or Russia increased the demand for government bonds and thus lowered the interest rates payable by OECD countries. In the future, reserves will increasingly be held in other forms, such as gold, cryptocurrencies, or possibly even emerging market government bonds. A reallocation of the currency reserves of non-Western countries will also make a further contribution to the rise in the interest rate level in OECD countries.

A third consequence of the financial sanctions is political: The financial sanctions affect all countries trading with Russia, but non-Western countries were not consulted or even asked for approval before the sanctions were imposed. In India, for example, this is causing continuing disgruntlement. The British Guardian scoffed at the end of July that the sanctions were “based on the neo-imperial assumption that western countries are entitled to order the world as they wish” and nothing more than “feel-good symbolism”. For the strategically much more important geopolitical conflict with the People’s Republic of China, the anger of Asian, South American, and African countries over the way sanctions were imposed is a bad omen.

Third, and finally, the sanctions have consequences for international trade in goods and services. The former chief economist and current professor at Yale University, Pinelopi Goldberg, already pointed out in March 2022 that the trade sanctions harmed all states and were the final nail in the coffin for the rules-based international trade order. In the 1930s, trade conflicts were the harbingers of World War II. A comparable escalation is not inevitable, but certainly the sanctions strengthen the striving for a higher degree of self-sufficiency in many states of the world, including Western Europe. Germany in particular, which after the devastating sanctions of World War I in the 1930s relied first on autarky and after 1945 on the international division of labor, should end the misguided path of economic sanctions. Their benefits are limited, but the collateral damage caused by the sanctions, including the consequences of the Russian counter-sanctions for European and Non-European economies, is enormous.