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Only a Financial NATO Can Win the Economic War

The West’s sanctions abroad will fall short without cooperation on bailouts at home.

A picture taken on February 24, 2022 shows a video-conference of G7 leaders on Ukraine at the Elysee Palace in Paris.
A picture taken on February 24, 2022 shows a video-conference of G7 leaders on Ukraine at the Elysee Palace in Paris.
A picture taken on February 24, 2022 shows a video-conference of G7 leaders on Ukraine at the Elysee Palace in Paris. LUDOVIC MARIN/POOL/AFP via Getty Images

Putin’s War

An unprecedented global alliance of democracies has imposed crushing sanctions on Vladimir Putin’s regime as punishment for its invasion of Ukraine. Russia is being ejected from the networks that bind the global economy as companies from the United States, Europe, Japan, South Korea, Taiwan, and elsewhere cut off exports and evacuate their assets and staff. Without ongoing access to modern technology and foreign expertise, Russia’s planes will stop flying, its military hardware will degrade, and even its ability to extract hydrocarbons and grow food will be imperiled. The country is now enduring an economic crisis worse than anything since the collapse of the Soviet Union.

The astonishing speed, scale, and scope of the allied response to the Russian assault demonstrates the centrality of the economic and financial battlefield in modern warfare. To dominate this new arena, the allies should establish permanent mechanisms to maximize coordination during the current crisis—but also future ones. They should also develop doctrines and rules of engagement for economic conflicts of this kind, and invest in enhancing their ability to project economic and financial power to deter future breaches of international peace. Done right, the democracies will be able to preserve the benefits of globalization for everyone without undermining their ability to enforce necessary norms of behavior.

The allies’ strength comes from the size of their domestic markets, their dominance of the production of critical goods and services, and their centrality in the international financial system. But the allies’ coercive powers will be limited unless they can find a way to offset the significant domestic costs of their policies. The political consensus in favor of resisting Russian aggression will fracture if enough businesses start to lose money, lay off workers, and write down their investments. Putin is surely counting on this to lead to the premature removal of sanctions.

An unprecedented global alliance of democracies has imposed crushing sanctions on Vladimir Putin’s regime as punishment for its invasion of Ukraine. Russia is being ejected from the networks that bind the global economy as companies from the United States, Europe, Japan, South Korea, Taiwan, and elsewhere cut off exports and evacuate their assets and staff. Without ongoing access to modern technology and foreign expertise, Russia’s planes will stop flying, its military hardware will degrade, and even its ability to extract hydrocarbons and grow food will be imperiled. The country is now enduring an economic crisis worse than anything since the collapse of the Soviet Union.

The astonishing speed, scale, and scope of the allied response to the Russian assault demonstrates the centrality of the economic and financial battlefield in modern warfare. To dominate this new arena, the allies should establish permanent mechanisms to maximize coordination during the current crisis—but also future ones. They should also develop doctrines and rules of engagement for economic conflicts of this kind, and invest in enhancing their ability to project economic and financial power to deter future breaches of international peace. Done right, the democracies will be able to preserve the benefits of globalization for everyone without undermining their ability to enforce necessary norms of behavior.

The allies’ strength comes from the size of their domestic markets, their dominance of the production of critical goods and services, and their centrality in the international financial system. But the allies’ coercive powers will be limited unless they can find a way to offset the significant domestic costs of their policies. The political consensus in favor of resisting Russian aggression will fracture if enough businesses start to lose money, lay off workers, and write down their investments. Putin is surely counting on this to lead to the premature removal of sanctions.

Fortunately, the allies’ economic dominance means that they can spend nearly unlimited sums to offset these costs by supporting their own businesses during times of crisis. As we saw during the pandemic, rich countries face few material constraints when it comes to compensating firms for lost sales due to government policies. This power should be used to amplify the impact of sanctions, defend domestic economies from adversaries’ actions, and support postwar reconstruction in allied states and vanquished enemies alike.

Right now, however, this power remains underdeveloped. The problem is that the allies do not think of themselves as a cohesive bloc. Collective action problems are needlessly limiting the allies’ ability to deploy economic and financial instruments for foreign-policy ends. Each individual country in the coalition has its own fiscal capacity and its own exposure to losses from sanctions. There is a significant danger that these distinctions will eventually undermine allied cohesion, especially in Europe. The democratic coalition will need to transcend nationalist tendencies to realize its full potential as a force for international peace.

The allies should therefore establish a formal mechanism to pool and manage their considerable resources for strategic purposes. There is no existing institution that includes the full range of allies arrayed against Russia or one that has the necessary administrative and technical capabilities. A “Freedom Fund” is needed to give the democratic coalition a decisive advantage on the economic battlefield in both offensive and defensive operations.

The more the allies are willing to use their economic might at home, the more damage they can inflict on Russia by imposing the harshest possible sanctions.

Russians spent about $370 billion on imports in 2021, with the majority of that spending going to imports from Europe, the United States, Japan, and South Korea. Exporters in the allied countries could therefore lose hundreds of billions of dollars of sales if Russians are no longer able to buy goods and services produced abroad.

At the same time, banks headquartered in the United States, Europe, and Japan had about $150 billion in credit exposure to Russian borrowers, as of last summer. Since most of those borrowers are now banned from earning the income needed to pay their debts, most of those claims are now worthless. Shares of Raiffeisen Bank, an Austrian lender with a substantial exposure to Russia, have plunged more than 50 percent since the crisis began.

There is no way to put the screws to the Putin regime without squeezing the profits of Italian fashion houses, French winemakers, Belgian diamond merchants, British lawyers, U.S. aircraft manufacturers, German carmakers, and Austrian bankers. This was why the Russian government leaned on European business associations before the invasion in the hope of dissuading a vigorous response.

Some of the allies might find it prohibitively expensive to cover these costs for a sustained period of time, especially those bound by the European Union’s strict limits on government borrowing and on state aid to companies. They might be forced to abandon sanctions prematurely, giving the Putin regime space to continue the war. Looking ahead, economic sanctions would have no hope of deterring the Chinese government from invading Taiwan if each of China’s trading partners were expected to bear the costs alone.

Collectively, however, the allies have more than enough money to compensate everyone for the loss of the Russian market or even (hypothetically) the Chinese one. The yearly economic output of Austria, for example, is worth only about $440 billion, but the combined economic weight of the allies is nearly $60 trillion. (Chinese residents spent $3 trillion on imports last year.) Spreading the pain across the broadest possible array of countries through a supranational Freedom Fund would minimize the allies’ financial constraints and allow resources to be distributed fairly.

Meanwhile, self-imposed import bans, the ongoing fighting in the Black Sea, Russian export restrictions, and the degradation of Russia’s fixed assets are reducing the usable supply of many essential commodities, including wheat, fertilizer, neon, fossil fuels, and industrial metals. The allies can limit the impact by cooperating to release their strategic reserves, recycle reusable materials, boost domestic production, and, when necessary, ration consumption. The Freedom Fund mechanism could help the allies coordinate their efforts and sustain pressure on the Putin regime for as long as necessary to bring it to heel.

The Freedom Fund could also protect allies from acts of economic coercion initiated by others. If it were sufficiently large and credible, the Freedom Fund could deter hostile states from even considering the kinds of export controls, boycotts, and other sanctions that have been imposed in the recent past, most notably by the Chinese government. The Freedom Fund could be the central component of a mutual economic defense pact.

China has repeatedly bullied its neighbors and trading partners using economic means. In 2010, the Chinese government responded to a territorial dispute with Japan by effectively imposing an embargo on exports of rare-earth metals used for electronics manufacturing. In 2017, the Chinese government attempted to punish South Korea for its deployment of a U.S.-made missile defense system by, among other measures, ordering Chinese travel agencies to stop selling Korean tour packages. When the Australian government called for an international investigation into the origins of the COVID-19 pandemic, the Chinese government responded by banning imports of Australian barley, coal, wine, and other products. Most recently, the Chinese government more or less deleted Lithuania from its customs registry, effectively cutting the country off from both exports and imports, because it had the temerity to change the name of the Taiwanese government’s local diplomatic office.

In each case, the targeted countries were left largely to their own devices to manage the consequences. South Korea, Australia, and the EU (on behalf of Lithuania) all issued protests at the World Trade Organization (WTO), to little avail. The WTO’s dispute settlement process is simply too slow to help in these situations even when it is working smoothly. Moreover, even if the WTO had somehow ruled against the Chinese government in a timely manner, there is no mechanism to force China to pay compensation for the losses it caused. Moral victories do not pay the bills.

A fully operational Freedom Fund would neuter these attempts to bully. By pledging to support one another’s businesses through boycotts, embargoes, and other measures, the allies would be able to maintain an almost impenetrable financial defense. Buying Australian wine and holding it in storage, for example, would be trivial for the allies but a meaningful response to Chinese bullying—and it might not even cost anything. This defensive capacity should encourage more countries to join the mutual economic defense pact, which also expands the potential power of any future offensive operations supported by the Freedom Fund.

The crises of the past few years have severely weakened the trend toward economic integration. No less an authority than Adam Posen, the president of the Peterson Institute for International Economics, has declared that “it now seems likely that the world economy really will split into blocs” as a result of what one of us has described as “unrestricted financial warfare.” Perhaps surprisingly, the measures we suggest could help lean against this trend.

Right now, businesses face a stark choice. They can engage with potentially problematic regimes to make money, as they have done for years, but now with the full knowledge that this comes with the risk of losing everything if their foreign partners end up doing something so egregious that it merits the deployment of Russia-style sanctions. Alternatively, they can leave money on the table by voluntarily withdrawing to so-called safe countries.

Policymakers also have to make a similar choice: either continue to use markets and economic integration as instruments of promoting international peace or encourage companies to preemptively isolate countries that have, as yet, done nothing as flagrant as the Putin regime. The danger is that pushing disengagement or decoupling could actually promote international aggression, as Nicholas Mulder warns in his new history of sanctions in the 1920s and 1930s.

Our proposal neatly avoids this dilemma. Since the Freedom Fund promises to compensate businesses for the costs of sanctions imposed on countries that violate international peace, managers can focus on investing anywhere they are allowed to do so in ways that make sense for them. Likewise, policymakers could offer every country a clear choice: either operate within the rules of the international system and prosper or reject those rules and face severe consequences. Governments may sometimes have to give money to companies that did well by selling to unsavory regimes, but that’s far better than the alternatives. Capitulating on questions of war and peace for economic reasons would be pathetic, while cutting off large parts of the global population from the benefits of modernity out of fear would be both miserly and counterproductive.

The moral hazard that would be created by the Freedom Fund would also make it easier for the allies to turn sanctions off. The allies should want their businesses to return to Russia quickly if the government adjusts its behavior sufficiently. But that won’t happen if those businesses fear they might one day lose out again from future sanctions. Limiting the downside for firms that reengage with Russia should prevent this kind of overcompliance, even if sanctions eventually have to be reapplied.

Finally, the Freedom Fund could also help mobilize necessary resources to aid in the reconstruction of Ukraine and, more speculatively, a post-Putin Russia. The ability to spend money means we can be generous in victory. Monetary aid to Russia after the breakup of the Soviet Union was derisory when compared with what most of the other former Warsaw Pact states got as they integrated with the West.

Ukrainian President Volodymyr Zelensky concluded his speech to the U.S. Congress by calling for “new tools to respond quickly and stop the war … new institutions, new alliances.” Part of the world’s response to Russia’s war in Ukraine should be a Freedom Fund that increases the credibility of sanctions and the resilience of liberal democracies over the long term, in turn increasing deterrence and lowering the chances of a new conflict.

Matthew C. Klein is the founder of the Overshoot research service and the co-author of Trade Wars Are Class Wars.

Jordan Schneider is an analyst at the Rhodium Group and the host of the ChinaTalk podcast.

David Talbot is a former international economics advisor to the U.S. commerce secretary.

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