Putin, Ukraine, and Time Inconsistency

There is a misguided debate swirling around Ukraine’s gradual descent into civil war. It concerns the ability of the West to inflict economic pain upon Vladimir Putin’s Russia. Given the unwillingness of the NATO countries to use armed force in Ukraine and the superiority of Russia’s official and unofficial troops, the potency of Western economic sanctions might seem to be the full measure of Ukraine’s defense.

In support of sanctions’ efficacy, the International Monetary Fund last week issued warnings about the looming damage to Russia’s economy. As quoted in the Wall Street Journal, the IMF’s top official in Russia

…said it was difficult to assess the economic implications of these sanctions but together with geopolitical risks they are clearly killing private, state and foreign investment in Russia. He said that Russia is already in recession…

…The fund now predicts that Russian economic growth could be 1% in 2015. Previously, the IMF had forecast Russia’s gross domestic product to grow by 2.3% next year, which is still well below the annual oil-fuelled growth of 6% registered between 2000 and the global financial crisis in 2008.

While 1 percent growth would be a step back from better years, it is not exactly a disaster. It is the growth rate the IMF forecasted last month for France in 2014.

Sanctions skeptics, such as Anatole Kaletsky, ask, "Why did the U.S. and European sanctions against Russia (last) week trigger a rebound in the ruble and the Moscow stock market?" He argues that measures to date have been ineffectual. Further, the sanctions approach transforms an immoral act into an economic transaction with a finite price. Even if the West managed to impose more damaging measures, "For Russia, a weaker ruble and an economic recession are clearly a price worth paying for recapturing Crimea."

The problem with this whole debate is that the fear inspired by a weapon depends on both the damage that weapon might wreak and on the perceived likelihood that the weapon will be used. We can stipulate that a concerted effort by the G7 countries to inflict economic pain on their erstwhile G8 partner could take a serious toll. This would certainly involve moving beyond the more targeted sanctions that have been applied to date and on to measures that would affect broader swaths of the Russian economy.

Assuming the West has the capability, will it deploy the weapon? There are at least two serious obstacles. The one that has received the most attention is the coordination problem between the United States and Europe. Serious sanctions would hurt Europe and its industries significantly more than they would hurt the United States, given closer economic ties between the European Union and Russia. The Financial Times reports that German "business leaders, worried about the potential loss of Russian gas supplies and export markets, make no bones about opposing sanctions…" The upshot was that a meeting between President Obama and Chancellor Merkel led to warnings of broader sanctions if the May 25 elections in Ukraine were impeded.

The timing was an interesting contrast with that set out by Ukraine’s interim prime minister, who on May 1 said Ukraine was facing its "most dangerous 10 days." He feared that "the secessionists will put on a bigger show of strength on May 9, the commemoration of the Soviet Union’s victory over Nazi Germany. On May 11, pro-Russian separatists who have seized government buildings in about a dozen cities in the Donetsk and Lugansk regions, plan to hold a referendum on independence and later unification with Russia." Other defense analysts have argued that Russia’s "window of opportunity" — based on troop readiness — runs until mid-May.

The timing bears all the features of the sort of strategic game analyzed by Finn Kydland and Edward Prescott (in Nobel Prize-winning work). They described situations of "time inconsistency," in which one side will make promises about actions it will take later (say, end-May). When later actually arrives, however, those actions are no longer optimal (hence the "inconsistency"). Kydland and Prescott were talking about things like capital taxation promises intended to lure investors, but the idea applies equally well to sanctions intended to deter Russian aggression.

This second, time-consistency obstacle may explain Russian behavior. Putin’s reasoning might be as follows: Even if sanctions would be devastating to the Russian economy, they will never be imposed. If he manages to create enough turmoil in eastern Ukraine so that the May 25 elections appear "absurd" or are pre-empted by a vote on autonomy from Ukraine, then the world will look very different. With eastern Ukraine lost to Kiev, Putin could then begin a series of international dialogues in which the parties could agree to go no further and could step back from painful sanctions that neither side really wants.

Why would he believe this? It describes recent history pretty well. After Russia’s war with Georgia in 2008, a short period of frosty relations ensued. But within months, the United States pressed for a "reset." After all, what good dwelling on bygones? Then, after the invasion of Crimea this year, there was fairly widespread acceptance among analysts that it was unlikely sanctions could dislodge the Russians from their new acquisitions. Discussions of sanctions turned instead to future red lines (as opposed to the old ones from the Budapest Memorandums of 1994, guaranteeing Ukraine’s territorial integrity).

Each time, when the moment arrived to take harsh measures, those actions were deemed futile and new warnings were issued about the future. The economists Kydland and Prescott diagnosed this sort of problem and warned that astute players would disregard the empty warnings. The laureates did offer a fix, as it happens: The party that can never follow through would like to pre-commit. That is one interpretation for legislation introduced last week by Sen. Bob Corker (R-TN), the ranking minority member on the Senate Foreign Relations Committee. The proposal would remove some elements of presidential discretion and pre-commit to a stiff sanctions response, based on Russian actions. There are problems with such an approach — it will not be tailored to the needs of the moment, nor will it allow for easy coordination with allies. But it would restore credibility in a way that could alleviate the time inconsistency problem.

In the present circumstance, the worst possible outcome would be one in which the West actually is committed this time, but fails to signal that effectively to Russia. Avoiding that miscommunication equilibrium should be a major goal of U.S. and European policy. Given recent history, Western credibility now matters far more than question
s of how many points could be knocked off Russian GDP by full-spectrum economic sanctions.