The American Way of Economic War - Paul Krugman (Foreign Affairs)

 The American Way of Economic War

Is Washington Overusing Its Most Powerful Weapons?

By Paul Krugman

Foreign Affairs, January/February 2024 Published on December 6, 2023

 

Suppose that a company in Peru wants to do business with a company in Malaysia. It should not be hard for the firms to make a deal. Sending money across national borders is generally straightforward, and so is the international transfer of large quantities of data.

But there’s a catch: whether or not the companies realize it, their transactions of both financial information and data will almost certainly be indirect and will probably pass through the United States or institutions over which the U.S. government has substantial control. When they do, Washington will have the power to monitor the exchange and, if desired, stop it in its tracks—to stop, in other words, the Peruvian company and the Malaysian company from doing business with each other. In fact, the United States could prevent many Peruvian and Malaysian companies from trading goods in general, largely cutting the countries off from the international economy.

Part of what undergirds this power is well known: much of the world’s trade is conducted in dollars. The dollar is one of the few currencies that almost all major banks will accept, and certainly the most widely used one. As a result, the dollar is the currency that many companies must use if they want to do international business. There is no real market in which the Peruvian company could exchange Peruvian soles for Malaysian ringgit, so local banks facilitating that trade will normally use soles to buy U.S. dollars and then use dollars to buy ringgit. To do so, however, the banks must have access to the U.S. financial system and must follow rules laid out by Washington. But there is another, lesser-known reason why the United States commands overwhelming economic power. Most of the world’s fiber-optic cables, which carry data and messages around the planet, travel through the United States. And where these cables make U.S. landfall, Washington can and does monitor their traffic—basically making a record of every data packet that allows the National Security Agency to see the data. The United States can therefore easily spy on what almost every business, and every other country, is doing. It can determine when its competitors are threatening its interests and issue meaningful sanctions in response.

Washington’s spying and sanctioning is the subject of Underground Empire: How America Weaponized the World Economy, by Henry Farrell and Abraham Newman. This revelatory book explains how Washington came to command such awesome power and the many ways it deploys this authority. Farrell and Newman detail how September 11 pushed the United States to begin using its empire and how its many constituent parts have come together to constrain both China and Russia. They show that although other states may not like Washington’s networks, escaping them is extremely difficult.

The authors also demonstrate how, in the name of security, the United States has created a system that is often abused. “To protect America, Washington has slowly but surely turned thriving economic networks into tools of domination,” Farrell and Newman write. And as their book makes clear, the United States’ efforts to dominate can cause tremendous damage. If Washington deploys its tools too often, it might prompt other countries to break up the current international order. The United States could push China to cut itself off from much of the world economy, slowing global growth. And Washington might use its authority to punish states and people that have done nothing wrong. Experts must therefore think about how to best constrain—if not quite contain—the United States’ empire.

DATA AND DOLLARS

The United States’ centrality in global finance and data transmission is not entirely unprecedented. The world’s leading power has always had outsize control over the world’s economy and communication networks. At the beginning of the twentieth century, for example, the British pound played a key role in many international transactions, and a plurality of all global submarine telegraph cables passed through London.

But 2023 is not 1901. Today’s era is defined by what some economists call “hyperglobalization.” The world is far more intertwined than it was a century ago. It is not just that global trade now makes up a larger share of economic activity than in the past; it is also that the complexity of international transactions is far greater than ever before. And the fact that so many of these transactions pass through banks and cables that the United States controls gives Washington powers that no government in history has possessed.

Many lay observers, and quite a few professional commentators, imagine that this dominance affords the United States great economic advantages. But economists who have done the math generally do not believe that the dollar’s special position makes more than a marginal contribution to the United States’ real income—the amount of money Americans make after adjusting for inflation. There do not appear to be any studies of the economic benefits that come from hosting fiber-optic cables, but those benefits, too, are likely to be small (especially because many of the profits that come from transporting data are probably booked in Ireland or other tax havens). But Farrell and Newman show that U.S. control of the world economy’s chokepoints does give Washington new ways to project political influence—and that it has seized on them.

The United States began capitalizing on these powers, the authors argue, after the 9/11 attacks in 2001. Before, American officials had been inhibited in exercising U.S. economic might by fears of overreach. But officials quickly realized they could have been following Osama bin Laden’s financial transactions in a way that would have revealed the terrorist’s plans and that they could have used their financial influence to disrupt al Qaeda’s operations. And so, after the terrorist group struck, Washington put its concerns aside. It expanded both its financial surveillance and its use of sanctions.

 

John Lee

 

For policymakers, exercising these powers proved easy. The dollars used in international transactions are not bundles of cash but bank deposits, and almost every bank that keeps such deposits must have a foot in the U.S. financial system in case it needs access to the Federal Reserve. As a result, banks around the world try to stay in the good graces of U.S. officials, lest Washington decide to cut them off. The story of Carrie Lam, the China-appointed former chief executive of Hong Kong, provides a case in point. As Farrell and Newman write, after the United States sanctioned Lam for human rights violations, she was unable to get a bank account anywhere, even at a Chinese bank. Instead, she had to be paid in cash, keeping piles of money at her official residence.

A less picturesque—but far more consequential—example of U.S. power is the way Washington co-opted the Society for Worldwide Interbank Financial Telecommunication, better known as SWIFT. The organization serves as the messaging system through which major international financial transactions are made. Notably, it is based in Belgium, not the United States. But because so many of the institutions behind it rely on U.S. government goodwill, it began sharing much of its data with the United States after the 9/11 attacks, providing a Rosetta stone that Washington could use to track financial transactions worldwide. In 2012, the U.S. government was able to use SWIFT and its own financial power to effectively cut Iran out of the world financial system, and to brutal effect. After the sanctions, Iran’s economy stagnated, and inflation in the country reached roughly 40 percent. Eventually, Tehran agreed to cut back its nuclear programs in exchange for relief. (In 2018, U.S. President Donald Trump scuttled the deal, but that’s another story.)

That is the kind of power the United States gets from its control over financial chokepoints. But as Farrell and Newman show, what the United States can do with its control over data chokepoints is arguably more remarkable. At many, or perhaps all, of the places where fiber-optic cables enter American territory, the U.S. government has installed “splitters”: prisms that divide the beams of light carrying information into two streams. One stream goes on to the intended recipients, but the other goes to the National Security Administration, which then uses high-powered computation to analyze the data. As a result, the United States can monitor almost all international communication. Santa may not know whether you’ve been bad or good, but the NSA probably does.

Other countries, of course, can and do spy on the United States. China, in particular, works hard to intercept advanced American technology. But no one does spying better than Washington, and despite Beijing’s best efforts, China has not been able to steal enough secrets to match U.S. prowess. As Farrell and Newman point out, the United States still dominates crucial intellectual property—not so much the software that runs current semiconductor chips, but the software used to design complex new semiconductors, which is still an essential market. “U.S. intellectual property,” the authors declare, winds “through the entire semiconductor production chain, like a fisherman’s longline with barbed and baited hooks.”

ALL THAT POWER

There are many illustrative examples of Washington weaponizing its underground empire, including the sanctioning of both Lam and Iran. But the one that may best show how all three elements of the empire—control over dollars, control over information, and control of intellectual property—come together is the astonishingly successful takedown of the Chinese company Huawei.

Just a few years ago, American officials and foreign policy elites were in a panic about Huawei. The company, which has close ties to the Chinese government, seemed poised to supply 5G equipment to much of the planet, and U.S. officials worried this spread would effectively give China the power to eavesdrop on the rest of the world—just as the United States has done.

So Washington used its interlocking empire to cut Huawei off at the knees. First, according to Farrell and Newman, the United States learned that Huawei had been dealing surreptitiously with Iran—and therefore violating U.S. sanctions. Then, it was able to use its special access to information on international bank data to produce evidence that the company and its chief financial officer, Meng Wanzhou (who also happened to be the founder’s daughter), had committed bank fraud by falsely telling the British financial services company HSBC that her company was not doing business with Iran. Canadian authorities, acting on a U.S. request, arrested her as she was traveling through Vancouver in December 2018. The U.S. Department of Justice charged both Huawei and Meng with wire fraud and a number of other crimes, and the United States used restrictions on the export of U.S. technology to pressure Taiwan Semiconductor Manufacturing Company, which supplies many crucial semiconductors, into cutting off Huawei’s access to the most advanced chips. Beijing, meanwhile, detained two Canadians in China and essentially held them hostage.

Santa may not know whether you’ve been bad or good, but the NSA probably does.

After spending almost three years under house arrest in Canada, Meng entered into an agreement in which she admitted to many of the charges and was allowed to return to China; the Chinese government then released the Canadians. But by that point, Huawei was a much-diminished force, and the prospects for Chinese dominance of 5G had vanished—at least in the near term. The United States had quietly waged a postmodern war on China, and won.

At first glance, this victory could seem like unambiguously good news. Washington, after all, limited the technological reach of a dictatorial regime without having to use force. The United States’ ability to cut North Korea off from much of the world financial system, or its successful sanctioning of Russia’s central bank, might also prompt rightful cheers. It is hard to be outraged by the United States’ use of hidden powers to block global terrorism, break up drug cartels, or hobble Russian President Vladimir Putin’s attempt to subjugate Ukraine.

Yet there are clearly risks in the exercise of these powers. Farrell and Newman, for their part, are worried about the possibility of overreach. If the United States uses its economic power too freely, they write, it could undermine the basis of that power. For example, if the United States weaponizes the dollar against too many countries, they might successfully band together and adopt alternative methods of international payment. If countries become deeply worried about U.S. spying, they could lay fiber-optic cables that bypass the United States. And if Washington puts too many restrictions on American exports, foreign firms might turn away from U.S. technology. For example, Chinese designed software may not be a match for the United States’, but it is not too hard to imagine some regimes accepting inferior quality as the price for getting out from under Washington’s thumb.

So far, none of this has happened. Despite endless breathless commentary about the potential demise of the dollar, the currency reigns supreme. In fact, as Farrell and Newman write, the dollar endured despite the “vicious stupidity” of the Trump administration. Laying fiber-optic cables that bypass the United States might be easier to accomplish, and people who are not technologists do not really know how easily U.S. software can be replaced. Still, Washington’s hidden power seems remarkably durable.

 

Reflections off of a currency exchange board in Buenos Aires, Argentina, September 2019

Agustin Marcarian / Reuters

 

But that does not mean there are no limits to how far the United States can push. Farrell and Newman worry that China, which is an economic superpower in its own right, might decide to “defend itself by going dark”: cutting off international financial and information linkages to the wider world (which it already does to some extent). Such an action would have significant economic costs for everyone. It would degrade China’s role as the workshop of the world, which—in its own way—might be as hard to replace as the global role of the U.S. dollar.

There is also the obvious risk that countries that lose wars without gun smoke could lash out by waging wars with gun smoke. As Farrell and Newman write, the weaponization of trade is one of the factors that contributed to World War II: Germany and Japan both engaged in wars of conquest, in part, to secure access to raw materials they feared might be cut off by international sanctions. The nightmare scenario for today would be if China, fearful that it is being marginalized, were to strike back by invading Taiwan, which plays a key role in the global semiconductor industry.

But even if the United States does not overuse its underground empire or provoke hot conflict, there is still a major reason to worry about Washington’s dramatic economic and data power: the United States will not always be in the right. Washington has made plenty of unethical foreign policy decisions, and it could use its control over global chokepoints to harm people, companies, and states that should not come under fire. Trump, for example, slapped tariffs on Canada and Europe. It is not hard to imagine that if he were to win a second term, he would try to hobble the economies of European states critical of his foreign or even domestic policies. One does not have to see everything through the lens of the Iraq war or insist that the United States somehow forced Putin to invade Ukraine to be worried about the underground empire’s lack of accountability.

RULES OF THE ROAD

Farrell and Newman do not propose policies that could mitigate these risks, other than suggesting that the underground empire deserves the same kind of sophisticated thinking once devoted to nuclear rivalries. Still, by highlighting how the nature of global power has changed, the book makes an enormous contribution to the way analysts think about influence. And policymakers and researchers should begin formulating plans for fixing these problems.

One possible resolution would be to create international rules for the exploitation of economic chokepoints, along the lines of the rules that have constrained tariffs and other protectionist measures since the creation of the General Agreement on Tariffs and Trade, in 1947. As every trade economist knows, the GATT (and the World Trade Organization that grew out of it) does more than just protect nations from each other. It protects them from their own bad instincts.

It will be hard to do something similar with newer forms of economic power. But to keep the world safe, experts should try to come up with regulations that have the same moderating effect. The stakes are too high to let these challenges go unaddressed.

 

• PAUL KRUGMAN, winner of the 2008 Nobel Prize in Economics, is Distinguished Professor of Economics at the Graduate Center of the City University of New York.

 

Gazprom grapples with collapse in sales to Europe -Financial Times

Gazprom grapples with collapse in sales to Europe 

Business model in tatters after biggest customer slashes 

Financial Times, Feb 17, 2024

Gazprom grapples with collapse in sales to Europe.

Vladimir Putin was effusive late last year after Gazprom reported record sales to China, telling chief executive and longtime ally Alexei Miller: “This is great, I congratulate you on the results of your work.” 

But the Russian president’s praise, proudly trumpeted on state media, belies the crisis unfolding at a company that is struggling with the loss of its biggest market. Europe has defied expectations by breaking its addiction to Russian gas, and the state-run gas monopoly — Putin’s trump card when he launched his full-scale invasion of Ukraine — has become one of the war’s biggest corporate casualties. “Gazprom understands that it will never again have as big and fat a slice of the pie as Europe, and it simply has to accept that,” said Marcel Salikhov, head of the Institute for Energy and Finance, a Russian think tank. “The only way forward now is to look for relatively smaller sources of revenue and gradually develop them, gathering crumbs.” In an interview with state television channel Rossiya 1 on Sunday, Putin admitted Russia had previously profited more from exporting energy, but denied the loss of business was causing problems. “Maybe it was more fun [previously], but on the other hand, the less we depend on energy, the better, because the non-energy part of our economy is growing,” he said. While Moscow decided early in the war to slash gas supplies to Europe, a move that initially boosted prices enough to offset the slump in exports, the effect was shortlived. Pre-tax earnings hit a record Rbs4.5tn ($49.7bn) in the first six months of 2022 but slumped 40 per cent to Rbs2.7tn a year later, while net profits slid from almost Rbs1tn to Rbs255bn. 

Researchers at the state-controlled Russian Academy of Sciences have even predicted the company’s full-year 2023 results will show it has ceased to be profitable, and that net losses could hit Rbs1tn by 2025. The EU has proved more adept at sourcing alternative gas than many thought possible — Russia’s share of the bloc’s gas imports dropped from more than 40 per cent in 2021 to 8 per cent last year, according to EU data — while prices have collapsed from their peaks in the early days of the war. 

The EU is aiming to eliminate all imports of Russian fossil fuels by 2027. On Sunday, Putin said Russia had coped well after Europe stopped buying its gas, “by exploring alternative routes and focusing on its own gasification efforts.” But in reality these are not a replacement for the EU export business. With its main export business in tatters, Gazprom has sought to find new buyers but its deals in central Asia and minor supply boosts to China and Turkey will compensate for only 5 per cent to 10 per cent of the lost European market, according to Salikhov. Achieving any substantial change in this scenario will require enormous investment in pipelines and other infrastructure to serve new markets, as well as the involvement of external partners that are in less of a hurry to commit. When the invasion began, Gazprom appeared to be in a much better position than other Russian energy exporters given that the country’s gas, unlike its oil, was not under any western sanctions. But its prospects changed in September 2022 when underwater blasts ruptured the Nord Stream gas pipelines that had carried 40 per cent of Russia’s gas exports to Europe, drastically reducing Moscow’s ability to use the fuel as leverage. Moscow and the west have accused each other of sabotage. Gazprom did not reply to a request for comment. The Russian market, which has always accounted for a much bigger share of the company’s output than Europe, has helped it stay afloat but with gas sold at a much lower price domestically, local sales cannot make up for the collapse of the EU market. Gazprom has to sell gas domestically at regulated prices, while competitors such as Rosneft and privately-run Novatek can offer discounts to attract bulk buyers. “After the war started, Gazprom intensified its efforts to ensure fair competition on the Russian market with the lifting of domestic price restrictions,” said Irina Mironova, a lecturer at the European University at Saint Petersburg, who previously worked as an analyst at Gazprom. Critics have long suggested that Putin has used the group to funnel profits to his acolytes — although the subject remains taboo in Russia. State-owned Sberbank’s investment arm in 2018 sacked two senior analysts after they published a report saying Gazprom deliberately opted for unprofitable projects to secure lucrative contracts for companies owned by the president’s close friends Gennady Timchenko and Arkady Rotenberg. Gas emanating from a leak on a Nord Stream pipeline in the Baltic Sea in 2022. Moscow and the west have accused each other of sabotage 

“Gazprom’s model, which consisted of generating excessive profits in Europe and then distributing them among contractors close to Putin . . . no longer exists,” said Vladimir Milov, a former deputy energy minister who was the architect of Gazprom’s reforms in the early 2000s and who later became an associate of opposition figure Alexei Navalny, who died in an Arctic penal colony on Friday according to Russian authorities. 

The primary recipient of Gazprom’s profits is now the Russian state, which shortly after the invasion imposed an additional monthly levy of Rbs50bn on the company until 2025. While gas exports to China have risen, the volumes remain relatively small — Russia sent about 22bn cubic metres of gas to the country via pipeline last year, a fraction of the average annual 230 bcm it exported to Europe in the decade before the Ukraine war. The company could improve its prospects if it reaches an agreement on the construction of the 3,550km “Power of Siberia 2”, which would connect the gasfields that once supplied Europe to China, and a second pipeline to the Asian nation. 

However, Beijing and Moscow have yet to agree on the PS2 project, which will pass through Mongolia. “Those two sides still need more time to do more detailed research on the economic studies,” Mongolia’s Prime Minister Luvsannamsrain Oyun-Erdene told the FT in January. 

The gas group has become one of the war’s biggest corporate casualties. 

Even under the most optimistic scenario the PS2 would take years to build and would not make up for lost European sales, independent analysts and state-sponsored researchers agree. Construction of the pipeline will also be different from other Gazprom projects, as it will most likely be financed from the state budget — which has historically enjoyed generous contributions from the gas company — and not from Gazprom’s excess profits. Meanwhile, while Russian liquefied natural gas exports are gradually increasing, they remain a fraction of the prewar pipeline deliveries. Novatek accounts for most of Russia’s LNG exports, with Gazprom lacking the specialised infrastructure to convert and transport the liquid form of the fuel, having bet on pipelines rather than liquefaction technologies at the dawn of the Putin era. Gazprom’s oil business, Gazprom Neft, has become the company’s main lifeline, contributing 36 per cent of revenues and 92 per cent of net income in the first half of 2023. The division’s market value even surpassed that of its parent company last year. “Oil is not a side business for Gazprom, it is not just the cherry on the cake — it is the entire layer of it,” said Sergey Vakulenko, a former head of strategy at Gazprom 

Neft who is now a non-resident scholar at the Carnegie Russia Eurasia Center. 

Gazprom’s oil business, Gazprom Neft, has become the company’s main lifeline © Oliver Bunic/Bloomberg 

He also noted Gazprom’s generous dividends to shareholders including the state had often been very close to the sum of dividends it received from Gazprom Neft. However, he described the group’s position as “not great, not terrible”, insisting “the company isn’t yet on the verge of collapse”. 

Ron Smith, oil and gas analyst at Moscow-based BCS Global Markets, also said Gazprom’s financial position was not yet “catastrophic”. But the company faces the risk that its fortunes and prospects will never be the same again.

Uma nova forma de sanção econômica contra a Rússia: um preço-teto para o seu petróleo - Edward Fishman and Chris Miller (Foreign Affairs)

 The Right Way to Sanction Russian Energy

How to Slash Moscow’s Revenues Without Crippling the Global Economy

Edward Fishman and Chris Miller

Foreign Affairs, Nova York - 17.5.2022

 

Western sanctions are beginning to hit Russia where it hurts most: its energy exports. Over the last few weeks, the European Union, the biggest buyer of Russian oil, has been working on a plan to ban imports by the end of this year, although objections by Viktor Orban of Hungary have slowed progress.

For energy sanctions to work, however, they must be carefully designed to hurt Russia more than they hurt Western states. Their primary goal should not be to cut the volume of oil and gas leaving Russia, which would further drive up world energy prices and endanger domestic support, but to reduce the dollars and euros flowing into Russia. Moving forward, the EU should therefore focus collective efforts on a more ambitious approach: partnering with the United States and other allies to impose a global regime, backed by the threat of secondary sanctions, to cap the price of Russian oil and slash the Kremlin’s revenue. 

Prior rounds of sanctions against Moscow restricted investment and technologies destined for Russia’s energy sector, targeting the country’s refineries and its construction of liquefied natural gas infrastructure. Canada, the United Kingdom, and the United States also banned Russian energy imports, but this had limited impact because all three were small consumers of Russian oil and gas. Until recently, the biggest buyer of Russian energy—the EU—not only declined to sanction energy exports but also designed its financial sanctions to explicitly allow Russian fuel to keep flowing.

But now, the Russian-European energy relationship is unraveling. On top of its discussions about phasing out Russian oil imports, the EU also announced plans to completely end Russian natural gas imports over the coming years. Europe buys slightly over half of all Russian exports of crude oil and refined products such as gasoline, diesel, and jet fuel. Taxing these exports, meanwhile, currently provides around a quarter of Moscow’s budget. The EU effort to halt Russian oil purchases therefore represents a dramatic and welcome shift in the global response to Russia’s invasion.

But Europe’s plans also pose a challenge for Washington. Thus far, the United States has declined to impose the toughest sanctions on Russian energy, including the kinds of secondary sanctions that have been used against Iran to limit oil sales to third countries. This reluctance is explained by the Biden administration’s deference to the EU on matters affecting Europe’s energy security and concerns that reducing global oil supplies would send gasoline prices—and thus inflation—spiraling higher. But now that many Europeans are signaling that they are serious about cutting off Russian energy imports, the United States and its allies need a coordinated strategy. Together, they must figure out how to slash Russian energy revenue without unduly damaging the global economy.

 

CUTTING RUSSIAN REVENUE

 

If Washington and its allies are to make good on their intent to sanction Russian energy effectively, they will have to deal with a difficult dilemma. Russian tax revenue from oil is a function not only of the number of barrels sold, but also their price. The United States and Europe have plenty of tools to reduce Russia’s ability to sell oil, but the price is set on global markets. Because of the risk that sanctions pose to potential buyers, Russian firms must now sell their oil at a more than $30 per barrel discount on current world prices. But since the price of oil has increased substantially over the last 12 months, Russia is making roughly the same amount per barrel as it was a year ago. 

In other words, sanctions have a complex and contradictory effect on the world’s second-largest oil exporter. The more they succeed at taking Russian supply offline, the higher the world price of oil goes. This is particularly true when there are few immediate alternative sources on the global market to replace the lost Russian supply—precisely the current situation.

The EU’s embargo will exacerbate this dynamic by substantially reducing the amount of Russian oil reaching world markets. Most of Russia’s oil exports are sent abroad via ship, so they can, in theory, be sold anywhere. In practice, however, because around half of Russia’s exports of crude oil and refined products go to Europe, most shipborne exports touch European commodity traders, shippers, and insurers. EU sanctions threaten to prohibit Moscow’s use of some of this infrastructure, limiting Russia’s ability to ship oil to other potential customers.

Although there is some uncertainty about the impact, forecasts suggest that Russian exports would decrease by around 2 million barrels of oil and refined products per day if the EU halts all purchases. Russian government officials have given similar forecasts, foreseeing a 17 percent decline in Russian oil production this year. Given that Russia exported slightly less than eight million barrels of crude and refined products per day before the war, this is a substantial hit, and a meaningful reduction in world oil supply. For the Kremlin, however, such a decline is significant but far from catastrophic, as reduced production will inevitably drive oil prices higher. 

For energy sanctions to put real pressure on Russia’s government budget, they need to cut deeper. In April, according to the Russian Ministry of Finance, the government made around half a billion dollars per day taxing oil, roughly a quarter of Russian government revenue. A 17 percent decline in this figure would be painful but manageable. Moreover, because oil is priced in dollars, if the Russian government lets the ruble decrease slightly in value, it can reduce the impact of lower oil taxes on the government budget because each dollar of oil revenue will buy more rubles. In other words, although an EU embargo would be painful for Russia, it would be survivable. This is why Western countries need a new global framework—one that systematically reduces the price of Russian oil while keeping it flowing.

 

A REVERSE OPEC

 

Reducing the price of Russian oil while still allowing Moscow to sell significant volumes abroad would curtail the Russian government’s revenues without increasing global oil prices. A price reduction would hit Moscow directly, swiftly reducing the hard currency flowing into the Kremlin’s coffers. And if it were structured in the right way, the price cap would also provide incentives for everyone, including China, India, and even Russia itself, to comply.

To understand how, it is important to consider the tremendous leverage the United States, Europe, and other allies have over Russia’s oil sector. Currently, Europe accounts for roughly half of Russia’s sales of oil and refined petroleum products. Outside of Europe, other large buyers include Japan and South Korea, both of which have signed onto sanctions against Russia and should be amenable to measures that curb the Kremlin’s revenues.

The key to limiting the price of Russian oil is for these allied countries to band together and dictate terms. Think of it like a reverse OPEC: instead of wielding control over supply to set prices, the allies could leverage their control over demand to do the same. OPEC’s power is rooted in the fact that its members produce about 40 percent of the world’s oil. Europe, Japan, South Korea, and other members of the sanctions coalition account for an even greater share of Russia’s oil sales, roughly 60 or 70 percent. Members of the group, moreover, play critical supporting roles in Russia’s shipborne oil exports, from ports to shipping to maritime insurance. These links provide them with additional leverage beyond their purchasing power.

These states could form a buyers’ club that publicly announces a price cap for Russian oil. There’s room for debate about the right price, which would need to be high enough to keep Russia selling. Oil trader Pierre Andurand has proposed $50 per barrel, whereas financier and energy expert Craig Kennedy has suggested as low as $20. So long as the price is slightly above the marginal cost of production, Russia has every reason to keep shipping. In prior periods of low prices, such as 2014 and 2020, Russia continued to export roughly constant volumes of oil. Although Russia could theoretically halt exports, its storage facilities are already mostly full. The Kremlin’s only alternative to selling on the cheap is to shut down production and watch its most critical industry go into a deep freeze while its tax revenue collapses.

Would other buyers agree to a price cap? Beyond the sanctions coalition, the biggest buyer of Russian oil is China, which generally consumes around 15 percent of Russia’s exports, largely via pipeline. Historically, India has not been a major buyer of Russian oil, but it has more than doubled its purchases in recent months to take advantage of discounted prices. Russia also sells oil to many other countries, such as Lebanon and Tunisia, but they are small buyers and can acquire the oil they need from alternative sources.

To bring these other states on board, the United States, Europe, and East Asian allies could enforce compliance by using sanctions to throw sand in the gears of Russian oil shipments that violate the price cap. They could start by imposing full-blocking sanctions on vital nodes in Russia’s oil sales, including Rosneft, the state-owned oil giant; Gazprombank, the main bank serving Russia’s energy sector; and Sovcomflot, Russia’s largest shipping company. At the same time, the United States and others could provide exemptions for oil shipments that comply with the price cap. Such a regime would make it prohibitively risky for global banks and companies to deal with those entities, unless the underlying transaction abides by the price cap. The dire risk of sanctions violations would compel firms involved in such transactions to insist on clear documentation demonstrating that oil cargoes are compliant.

Additionally, allied states could wield the threat of secondary sanctions against non-Russian companies involved in prohibited oil sales. For instance, if a Chinese or an Indian firm were to buy a shipload of Russian oil for a price above the cap, Western states could threaten sanctions against the shipping company that transports the oil, the insurance company that underwrites the cargo, any port operator that provides services to the tanker, and the banks that process associated payments. The same governments could also make it illegal for U.S. and EU firms to provide any of these services, making it very difficult for such a sale to proceed. The risk involved would force Russia to sell at even greater discounts than at present, in effect enforcing the price cap.

The United States used a similar regime to curb Iran’s oil exports, slashing Tehran’s oil sales by more than 60 percent and locking tens of billions of dollars of revenue in escrow accounts. A price cap on Russian oil would be more complex because Russia is a bigger supplier of oil, with more sophisticated international trade and financial linkages. Yet, compliance would not solely rely on the threat of sanctions. Critically, there would also be a positive incentive to comply: buyers of Russian oil would benefit substantially because abiding by the price cap would lower the cost of their own imports. Challenging the cap would be rife with financial risk and carry no economic benefit—it would be charity to the Kremlin. Amid the tightest world energy markets in years, there is little reason to believe Russia’s oil customers would be in a charitable mood.

Currently, only three major importers of Russian oil stand outside the sanctions coalition: China, India, and Turkey. China can continue to import Russian oil via a pipeline that is practically immune to sanctions. This pipeline, however, represents only a small share of Russian oil exports. Because the pipeline operates at capacity, if China wanted to significantly increase its imports of Russian oil, it would need to do so via ship, which already accounts for more than half of Chinese imports of Russian oil. Moreover, as the average price of Russian oil falls, China will likely negotiate a harder bargain for piped oil, further cutting into Moscow’s bottom line. India and Turkey, on the other hand, import much of their oil from Russia via shipping routes that are exposed to Western sanctions. Both are also economically vulnerable to high oil prices and would benefit greatly from lower prices. Although it is unlikely that either would publicly welcome a price cap, both would probably abide by it.

A price cap would be a major innovation in the use of financial sanctions. Given the challenges of sanctioning Russian energy exports, a traditional embargo applied globally would be difficult to implement and, even if it were possible, would send energy prices soaring. The United States and its allies would be better served by focusing on the goal of slashing Russian revenues while keeping enough Russian oil flowing to avoid a massive price spike. Imposing a reverse OPEC price cap on Russia, backed by Western sanctions, would benefit consumers the world over while focusing pressure on the petrodollars flowing into Putin’s coffers. 

 

EDWARD FISHMAN is an Adjunct Senior Fellow at the Center for a New American Security, a Nonresident Senior Fellow at the Atlantic Council, and an Adjunct Professor of International and Public Affairs at Columbia University. He served as a member of the Policy Planning Staff and as Russia and Europe Sanctions Lead at the U.S. Department of State from 2014 to 2017.

 

CHRIS MILLER is an Assistant Professor at the Fletcher School and Jeane Kirkpatrick Visiting Fellow at the American Enterprise Institute.

Economic sanctions: the cost for everyone - Adam Tooze reviews the data

 

Chartbook #97: Is boycotting Russian energy a realistic strategy? The German case. 

Adam Tooze Mar 12

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How do you weigh the effectiveness of an economic weapon? How do you gauge the likely impact on your antagonist? How do you assess the cost to yourself? 

As Nick Mulder has shown us in his powerful new history of the economic weapon, the calculus of sanctions is one of the important domains in which economic and social scientific expertise first came to the fore in 20th-century government.

Today Europe faces the question of how to respond to Russia’s invasion of Ukraine. 

The most obvious way to apply maximum financial pressure to Russia is to stop purchases of oil and gas. Russia’s export earnings are surging. The largest part of that revenue comes from Europe. 

Robin Brooks @RobinBrooksIIF

Russia just published its current account surplus for February. We compare Feb. 2022 to the same month in previous years. This year is off the charts (red), because the rise in energy prices - due to Putin's invasion of Ukraine - confers a huge hard currency windfall to Russia...

March 11th 2022

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Stopping oil and gas purchases would clearly deal a severe blow to Russia. But what would such a boycott cost Europe? 

Compared to the suffering of Ukraine the answer, of course, is that the costs will be slight. But no responsible government can avoid taking the costs seriously and weighing the balance. Apart from anything else, if we are in for a long economic war with Russia then we have to ensure that sanctions can be sustained. 

Deliberately shutting off a large part of one’s network of energy supplies would be a dramatic demonstration of solidarity with few precedents outside actual wartime. It is the scale of action demanded by climate activists and climate experts, but commonly dismissed as “unrealistic”. The scale and type of economic shock that would be delivered to Europe’s economies - a huge “supply shock” - is most closely paralleled by the actions taken in response to the COVID crisis. As we know from recent memory the pain was intense. The hardship fell unequally on those with low incomes and the measures were highly controversial. We have not yet digested the full impact of COVID. Will Europe’s governments make a second dramatic choice over Ukraine? And how can the costs and benefits be assessed? 

Nowhere is this decision weightier than in Germany, Europe’s economic great power. Germany is the key to any European boycott because it buys so much Russian energy. By the same token the impact on the German economy of ending energy imports from Russia is likely to be large. Energy has long been part of German statecraft, a way of exercising leverage and shaping its neighborhood. Will Berlin, faced with the current crisis, deploy the full force of the economic weapon? 

The basic facts are clear. Oil accounts for 32 percent of German primary energy input and one third of that comes from Russia. Gas accounts for 27 percent of Germany’s primary energy input, of which 55 percent comes from Russia. Of the coal burned in Germany, which accounts for 18 percent of energy input, 26 percent comes from Russia. All told that means that just over 30 percent of Germany’s primary energy input comes from Russia. 

Pipeline gas is the key issue because it cannot be easily substituted by alternative sources of supply. 

At the political level, the decision must be agreed between the three parties in the traffic-light coalition, with Chancellor Scholz and Robert Habeck at the Ministry for Economic Affairs and climate playing key roles.

So far the Economics Ministry has taken a cautious position. Habeck has described the consequence for the German economy of boycotting Russian energy as being of the “heaviest proportions” (schwersten Ausmaßes).

That sounds dramatic and the scale of dependence is clearly large. But how do we actually calibrate the likely cost? Only economic expertise can give us any idea as to the orders of magnitude. 

The German economics profession, it cannot be repeated too often, is no monolith. It is a world in motion. The problem of an energy boycott is not one that can easily be resolved by reference to familiar positions on inflation, long-term fiscal sustainability etc. 

No doubt the analysts in the German economics ministry are burning midnight oil. So far, their calculations have remained behind closed doors. But in the last week the expert debate has spilled into the public sphere. 

On March 8 the Leopoldina National Academy of Science published a paper focusing on the technical possibilities of substituting non-Russian sources of energy. They offered a practical to do list of measures with the conclusion that 

Even an immediate supply stop of Russian gas could be “handled” by the German economy (handhabbar). There may be shortages in the coming winter, but there are options, through the immediate implementation of a package of measures, to limit the negative effects and to cushion the social impact. .

The authors of the Leopoldina memo were in the main Professors in STEM fields. Economists (Grimm, Schmidt, Wagner … apologies to anyone else I missed) were in a small minority and the memo offered no estimate of the likely costs of the measures they suggested. 

The economic question was mapped the same day by a paper co-authored by a distinguished group of economists working both inside and outside Germany. 

The team consists of Rüdiger Bachmann: University of Notre Dame, David Baqaee: University of California, Los Angeles; Christian Bayer: Universität Bonn; Moritz Kuhn: Universität Bonn und ECONtribute; Andreas Löschel: Ruhr University Bochum; Benjamin Moll: London School of Economics; Andreas Peichl: ifo Institut für Wirtschaftsforschung, Universität München; Karen Pittel: ifo Institut für Wirtschaftsforschung, Universität München; Moritz Schularick: Sciences Po Paris, Universität Bonn und ECONtribute with research support from Sven Eis.

It is a truly broad church group with no obvious political or institutional alignment in Germany’s spectrum of foundations and think tanks. 

Everyone interested should check out the paper. It is technically sophisticated, using a state of the art global trade model, but it is written both in English and German and it is, as far as I am able to judge, comprehensible in its basic logic. We are very much in their debt for the speed and sophistication of this preliminary estimate. 

I’ll do my best here to relay some of their key points.

What happens if you cut off Russia as a source of supply depends on whether you can substitute other sources of energy and how far you can economize on energy use. 

Bachmann et al take as their main scenario the case in which total gas supplies fall by 30 percent with the result that Germany loses roughly 8 percent of its primary energy supply. What will be the impact on industry, households and the service sector? 

To provide a benchmark estimate they start from the multi-sectoral model of trade published by David Baqaee & Emmanuel Farhi in 2019. That model is a very ambitious attempt to model global trade as a set of general equilibrium flows.

The benchmark model has 40 countries as well as a “rest-of-the-world” composite country, each with four factors of production: high-skilled, medium-skilled, lowskilled labor, and capital. Each country has 30 industries each of which produces a single industry good. The model has a nested-CES (constant elasticity of substitution) structure. Each industry produces output by combining its value-added (consisting of the four domestic factors) with intermediate goods (consisting of the 30 goods). The elasticity of substitution across intermediates is θ1, between factors and intermediate inputs is θ2, across different primary factors is θ3, and the elasticity of substitution of household consumption across industries is θ0. When a producer or the household in country c purchases inputs from industry j, it consumes a CES aggregate of goods from this industry sourced from various countries with elasticity of substitution εj + 1. We use data from the World Input-Output Database (WIOD) (see Timmer et al., 2015) to calibrate the CES share parameters to match expenditure shares in the year 2008.33

One of the striking conclusions from the model is that the gains from trade may be much larger than is suggested by many standard models. 

For example, for the US, the gains from trade increase from 4.5% to 9% once we account for intermediates with a loglinear network, but they increase further to 13% once we account for realistic complementarities in production. The numbers are even more dramatic for more open economies, for example, the gains from trade for Mexico go from 11% in the model without intermediates, to 16% in the model with a loglinear network, to 44.5% in the model with a non-loglinear network.

This is important for the Russia sanctions debate because many trade models generate very modest gains from trade and correspondingly small effects from any interruption to trade. Indeed, if I read the Baqaee and Farhi paper correctly, it would also allows us to assess the impact of sanctions on Russia. I hope someone will soon perform the same kind of calculation that Bachmann et al have performed for Germany for the Russian side.

In choosing the Baqaee and Farhi model as their workhorse, Bachmann et al presumably hope to ensure that they capture the full effect of any trade interruption. Nevertheless, the results, in all scenarios, are surprisingly modest. 

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The workings of the Baqaee-Farhi model are very complicated, but the basic intuition is easy enough to follow. 

Energy is vital but it does not make up a huge share of expenditure (GNE, Gross National Expenditure). The only scenario in which an energy shock causes catastrophic damage is one in which there is literally no way of substituting or switching economic activities impacted by the loss of energy supply. This would be the case if the basic parameters of production are unalterably fixed - the so-called Leontief case. Taken at face value, that scenario would yield implausibly dramatic results. 

As soon as one assumes even a very small degree of substitutability, the effect of the energy supply shock is much more muted. According to the calculations by Bachmann et al, even in a worst case scenario the impact on GDP would come to 3 percent, which is less than the 4 percent shock that the German economy suffered in the COVID crisis.

As Bachmann et al remark

Purely in the spirit of being conservative, we therefore postulate a worst-case scenario that doubles the number without input-output linkages from 1.5% to 3% or €1,200 per year per German citizen. This number is an order of magnitude higher than the 0.2-0.3% or €80-120 implied by the Baqaee-Farhi model. We should emphasize that this is an extreme scenario and we consider economic losses as predicted by the Baqaee-Farhi model to be the more likely outcome

Bachmann et al also provide some pointers as to the distributional impact of any measures. As a share of income, heating and fuel costs do vary by income but not by as much as one might anticipate. 

A severe spike in gas and oil prices is likely to cause serious hardship only at the bottom end of the income pyramid, where support should be targeted. 

The Bachmann et al paper refrained from declaring the measures “manageable”, as the Leopoldina paper had done. But the scale of the losses they calculated certainly suggested that if sanctions were politically necessary they would be economically feasible. They recommended a cost mitigation strategy that cushioned low income consumers, but otherwise allowed the surge in energy prices to drive the search for energy efficiency. They also recommended that if sanctions were to be applied, they should be applied as soon as possible, so as to enable households and businesses to begin adaptation well before the fall and winter of 2022-2023, when supply difficulties will become most severe. 

Taken together the Leopoldina and Bachmann et al papers tended to increase the pressure for action. If alternatives to Russian oil and gas were technological feasible and the economic cost was no more than a few percentage points of GDP, the onus was on the politicians to make the choice. Was it not time for Germany to be brave?

When he was asked about the Bachmann et al study Minister Habeck responded that his Ministry estimated the likely impact of sanctions as far more serious. 

But how much more serious? The answer Habeck gave to journalists was a contraction of 5 percent. The significance of that figure is that it was worse than COVID.

Where did it come from?

In the days that followed the Leopoldina and Bachmann et al papers, other experts pushed back, expressing caution and even out-right skepticism about the estimates provided by their colleagues. 

Michael Hüther Director of the business-backed private research center Institut der deutschen Wirtschaft in Cologne took issue vociferously with the conclusions of the Leopoldina report. Declaring that a certain policy was “manageable” was a matter of value judgement Hüther insisted. 

Michael Hüther @michael_huether

Die dabei zitierten Studien zeigen nicht, dass man es machen kann oder machen sollte. Die Aussagen, ob dies "handhabbar" oder "machbar", sind reine Werturteile. Verantwortliche Politikberatung muss das deutlich machen. Über die Wirksamkeit der scheinbar "Handhabbaren" wird ...

March 11th 2022

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Later in the week two analysts from the Institute - Thilo Schäfer and Malte Küper - published a comment rebutting the idea that a gas and price stop was manageable. They insisted that it would involve “incalculable risks” and the certainty of a severe price shock with damaging effects for industry. 

But “incalculable” is not the same as 5 percent.

It was not just the Leopoldina report that was coming under fire. As reported by Handelsblatt, the Bachmann et al paper was criticized in a confidential paper for the Ministry for Economic Affairs and Climate authored by Tom Krebs and Sebastian Dullien. Whereas the Institut der deutschen Wirtschaft was business-aligned, Krebs and Dullien are aligned with the SPD and the trade union movement. When Olaf Scholz headed the Finance Ministry, Krebs took leave from his chair at Mannheim University to serve as a visiting professor. In April 2019 Dullien succeeded Gustav Horn as scientific Director of the Institut für Makroökonomie und Konjunkturforschung (IMK) the macro think tank of the Hans Böckler Foundation of the German trade union movement. 

In a paper presented to Habeck’s Ministry Dullien and Krebs apparently argued that Bachmann et al underestimated the likely impact of the shock. According to their calculations they thought a contraction of 4-5 percent of GDP more likely. 

Tom Krebs @tom_krebs_

Ein sofortiger Lieferstopp (cold turkey) von Gas und Öl aus Russland könnte eine neue Wirtschaftskrise verursachen. Warum das ein sehr wahrscheinliches Szenario ist – ein 🧵. 1/

March 11th 2022

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As Ben Moll one of the co-authors of the Bachmann et al paper pointed out, Krebs and Dullien did not offer a model to support their estimate. And, as Moll put it, “it takes a model to beat a model”. In fact, the Dullien and Krebs paper had never been intended for public discussion. It was leaked to the Handelsblatt. The IMK is now racing to run its own simulations to back up the initial estimate.

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Meanwhile, Dullien and Krebs found themselves in an unfamiliar alignment with Hüther and the team at the Cologne Institute. 

Michael Hüther @michael_huether

@tom_krebs_ Dazu: wir haben bereits vereinzelt Produktionsstillstand wg der hohen Energiepreise. Und: Angebotsprobleme bei kritischen Rohstoffen wie Palladium etc.

March 11th 2022

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Though the line between the two camps seemed clearly drawn, the striking thing is that the Krebs and Dullien estimate of 4-5 percent was not, in fact, dramatically different from the higher estimate by Bachmann et al. 

Given the uncertainties involved in the calculation, the divergence is not significant. 

After all, the point of the Bachmann et al paper was not to provide a very precise figure, but to gauge the likelihood of extreme negative outcomes. A 4-5 percent fall in GDP would be higher than their modeling suggested and much higher than any outcome suggested by the Baqaee and Farhi model, but it confirmed their broader conclusion that a catastrophe was unlikely. 

As Moll pointed out, Goldman and Sachs analysts had also arrived at a similar conclusion. Germany would be hit hard, but its economy would not suffer anything like a catastrophic shock. 

Ben Moll @ben_moll

Und hier noch die Grafik aus der Goldman-Sachs Studie die auf 3,5% kommt. 10/10

March 11th 2022

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So, if Krebs and Dullien felt they were at odds with Bachmann et al, the difference did not in fact lie in their estimate of the economic outcome to be expected, but in their evaluation, in political, social or other terms, of that outcome. 

As Moritz Schularick another co-author of the Bachmann et al paper told Handelsblatt: „The conclusion to be drawn should only be really be completely different, if we were talking about 20 or 30 percent.” That is, unless your premises in political, economic and social terms are different, or if beneath the apparent convergence on a prediction of 3-5 percent in GDP contraction you actually imagine very different realities.

Beyond the immediate protagonists in the four-way exchange, one senses other influential figures in the German economics scene aligning themselves on the question of sanctions. Clemens Füst, who heads the IFO institute in Munich, agreed with Krebs in warning of the possibility of cascade effects which result from single firms in production chains suffering sudden stoppages. If this was to occur on a large-scale the contraction in production would be larger than if the effect impacted evenly across the entire economy. 

Clemens Fuest @FuestClemens

Das ist meines Erachtens ein wichtiger Punkt den @tom_krebs_ hier hervorhebt:

Tom Krebs @tom_krebs_

@OdendahlC @GustavAHorn @michael_huether @FuestClemens @Leopoldina @PeterBofinger Der Produktionrückgang bei einem einzlenen Unternehmen kann Kaskadeneffekte auslösen -- siehe die Effekte des Halbleitermangels in 2021. Zumindest die Zulieferer in diesen Industrien, die sowieso schon fast am Ende sind, werden zusätzlich belastet.

March 10th 2022

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More speculatively, and somewhat tongue in cheek, what is one to make of the fact that Lars P Feld who advises Christian Lindner at the Finance Ministry tweeted out Nick Mulder’s jaundiced take on the history of sanctions published by The Economist? 

If one follows the Bachmann et al line it is tempting to say that the upshot of the economic analysis is that the cost to Germany of a boycott would be significant but not so significant that the idea can be dismissed as entirely unreasonable. Their analysis thus puts the ball back in the court of politics. That was the line taken by the Handelsblatt’s Julian Olk. 

But on closer inspection it seems that the separation between economic expertise and political judgement is not that neat. If one believes that the costs are, in fact, “incalculable” then excessively precise estimates of the likely costs will in themselves - regardless of the conclusions reached - tend to encourage an activist bias entailing considerable risks. Secondly, the divergent assessment of the meaning of similar estimates of GDP contraction suggests that GDP is insufficient as a measure to capture what rival camps think is essential about the economy. That may help to explain the caution of those who are closer to industry or labour and have to think through the implications of what a 3, 4 or 5 percent shock would actually mean for individual firms, supply chains and workers. Rather than a matter of bias that should be considered a matter of situated perspective, or standpoint. Closeness to “the interests” of producers reveals things that cannot easily be seen from the vantage point of a global macro model however sophisticated it may be. 

Certainly, if Berlin is to decide to go ahead with a boycott, what will be required will be a coalition-building exercise that will need to extend from the broader public, to key interest groups and to the realms of expertise, where the scale of the problem is being measured and assessed. Persuasion, calculation, mobilization and preparation is the work that would make a policy of full-scale sanctions realistic.