Europe’s Game – Part 1

Pro-Russian rebels held illegal elections in the Donbass on 2 November, which Russia first recognised then only “respected”. Meanwhile, Ukrainian authorities and NATO reported a serious Russian military build-up in Eastern Ukraine. Vladimir Putin was told off at the G20 summit, where even his face-to-face encounter with Angela Merkel went haywire. The British embassy in Kiev offered the Russian government a guide to identify its own armoured vehicles. You might have thought that if anytime Europe was ready to introduce new sanctions against Russia, it was now. If you did, you were wrong. EU member states failed to agree on new sanctions against Russia on Monday; instead, they chose to pretend something was happening and called to sanction rebel leaders. With the Russian economy on the verge of a serious crisis, the newest phase of the Ukraine crisis may just look like this: a chicken game, in which, before eventually losing, Putin might first score some political points.

Russia’s economy is, actually, nearing a serious crisis, the way out of which, if it eventually happens, will not be as quick and smooth as it was in 1998 or in 2008, when at least some external conditions were favourable for restarting growth. None are favourable now.

A looming crisis

The federal budget, adopted in the second reading, is based on an oil price of $100 per barrel, even though the actual price is now below $75 and, according to estimates quoted by the business daily Kommersant, may fall all the way to just $50 next year. Experts quoted by last week seemed to agree that the Russian economy could survive no more than two years with an oil price of $80. With a further negative outlook, and, most importantly, considering the psychological effect of increasingly nervous markets, the breaking point may as well come much earlier.

As I blogged earlier, troubles are intensified by a confidence crisis created by the crisis in Ukraine and Western sanctions. The increasing inability of Russian companies to obtain financing from abroad contributes to the fall of the rouble, and, as Vladimir Yakunin, the head of Russian Railways and a Putin confidant admitted last week, Chinese money will not be able to replace Western financing. China will not necessarily always play along with Russia to contain the rouble’s downfall either. Capital outflows this year are expected to reach $128 bn, according to the Central Bank, which is probably a conservative estimate. Capital outflows and a falling oil price have also prevented the Central Bank to credibly support the Russian currency, forcing it to move to a free float well before, as it was originally planned, the beginning of next year. Even with the still copious currency reserves (and growing gold reserves) of the Central Bank, even a little piece of bad news may be enough to push an already faltering economy further downhill. A new phase of sanctions, for example.

This time, though, the European country that is most able to coerce others into supporting such an initiative is having second thoughts as well. Albeit exports to Russia account for only 3.3% of total German exports, they have slowed 17% year-on-year (by Q2), a development deemed serious in an already slowing economy whose main strength has been its positive trade balance. The rift with Russia has negatively affected many of Germany’s Eastern European export markets and a looming financial crisis endangered the banking system in countries like Austria where exposure to Russia is the highest at 1.4% of total bank assets.

Economies suffering from the crisis include two ailing giants, France and Italy, the former being criticised for its stalled Mistral warship deal, deemed strategically important for growth in France, the latter risking contagion due to its close financial and trade relations with Russia. Germany is aware that, in a sharp contrast to 1998, Europe’s finances are squeezed. The EU cannot afford to respond with fiscal and monetary policies to contagion from Russia, prompting Germany to pursue a cautious, if not dovish, approach. Meanwhile, the serious decline of the UK’s influence in Europe is not yet compensated by the rise of the equally hawkish Poland.

Short-term effects of a Russian economic crisis would, without a doubt, be detrimental to Europe. They would, to some extent, hamper economic recovery. However, they would not be, as many think, disastrous. If Russia does enter a crisis, it will not be unexpected. Capital flights, cancelled investments and debt market restrictions show that Western companies and banks are aware of the risks and have already taken precautionary steps. The exposure of Western banks to Russia has significantly fallen. Sanctions have also been careful to prevent contagion as much as possible: Russian banks are only banned from seeking medium and long-term financing in Europe. The EU, as The Economist suggested, would also be able to finance a broken warship deal between France and Russia. Furthermore, some of the expected long-term effects of a Russian economic crisis – new, reinforced institutions, a more rule-abiding Russian economy, etc. – will benefit Europe.

However, driven partly by short-term political considerations and discouraged by the failure of sanctions to produce an instant political outcome, EU leaders are becoming increasingly reluctant. They are wrong.

Stick to your word

Vladimir Putin seems to have a simplistic view both on economics and on democracy. Economics is dry, boring and unclear to him; these are not my words: it’s the description Sergei Pugachev, Putin’s former banker gave of the Russian president. Putin also seems to think that the laws of economics are potentially dangerous if not tweaked by the state. Similarly, Putin seems to think that he understands democracy, which he thinks is fundamentally weak and unable to serve strategic goals, as it is based on superfluous deliberation and driven by short-term interests. If the Russian president is right, the new phase of the crisis in Ukraine is indeed a chicken game, allowing him to bully a reluctant European Union into giving in on Ukraine, e.g. through providing further military assistance to the rebels.

Putin is partly right. Weaker elasticity of political demand due to a critical media and freedom of thought does indeed cause democratic leaders to be more cautious. Nonetheless, it is exactly the rich amount of feedback that makes democracies more prosperous and successful. There’s no “lying your way to the truth”, as Razumikhin puts it in Dostoevsky’s Crime and Punishment, that Putin seems to think is possible in Russia. Stifling dissent, cracking down on alternative sources of information and refusing to hear criticism may enable Putin to troll Ukraine and the European Union now. Eventually, however, the lack of feedback, showcased by Putin’s storming out of the G20 summit in Brisbane may cost the Russian president dearly. It may, but not necessarily will.

Putin’s inner circle and Russian voters will agree that the president does not need to hear any feedback from them as long as he seems to be right: as long as Putin’s able to tell them “stay put – I can read Europe, I will take care of the rest”. And for the time being, he is. Little does it matter whether the conflict in Ukraine and the hysteria it created is a means to an end or it is the end itself; Putin is trusted by his voters because they have no reason to doubt him and he’s supported by his “enslaved” elite because they feel they cannot do anything else.

The downing of Flight MH17 was significant because it was unexpected: it prompted the European Union to step up sanctions and punish Russia harder than anyone in the Russian elite had assumed. It confused the Russian elite, weakened trust in Putin and set back the cause of the rebels. But then the EU became easy to read again. This is why Putin is becoming bolder.

Sanctions could work, but they need to defy Putin’s predictions. They need to break the galvanised mass that is Putin and the elite right now, and they need to break the Russian population enough to give birth to doubts. For this reason, they first and foremost need to be consistent. Europe has chosen to go down the road of sanctions; it shouldn’t stop halfway through. It has to trust that the laws of politics work the same way everywhere, even in Russia, even if different circumstances necessitate different incentives. Also, and this may be even more important, it has to trust its own democracies. According to a survey commissioned by the German broadcaster ZDF in September, more than half of German citizens backed stronger sanctions against Russia, even if it meant that the German economy would suffer.

Citizens are, apparently, capable of strategic thinking. Governments shouldn’t stint their efforts to convince them; or to convince the Russians, for that matter. After all, this is what democracy is all about.

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