Our Long Economic War with Russia

It is easy to imagine that when western central banks raise interest rates, stock markets tank, and economic growth slows, there are feelings of elation in the Kremlin that go far beyond schadenfreude. Indeed, one could imagine Russian state investors gleefully shorting western indexes and individual stocks. (In this post, I will use “west” or “western” to refer to the loose alliance of nations in Europe, NATO, and the OECD that oppose Russia.) It is this scenario that leads me to speculate about the course of the economic war between the west and Russia.

Leader for Life?

There is rampant speculation about the outcome of the military war in Ukraine. My expertise is in economics rather than military or strategic studies, so I will focus on the economic conflict.

Many experts are conjecturing that the failure of the Russian military on the ground in the Ukraine will jeopardize President Putin’s hold on power. If so, the question is what sort of leader would succeed him. If his successor is a Gorbachev one could imagine the possibility of a major diplomatic and economic rapprochement between Russia and the west. But leaders with views like Gorbachev are more likely to be in prison, like Navalny, than contenders for power within the Kremlin.

Stale Chips

If a hardline government is in power in the Kremlin, then even if the fighting stops in the Ukraine, the economic war between Russia and the west will continue. The key element of the western nations’ war with Russia will be a continued embargo on technology. By technology I am referring to computer chips, artificial intelligence, software, computers, and consumer and capital goods with embedded technology, such as commercial aircraft. These goods represent our comparative advantage relative to Russia. One motive for this embargo will be to punish the Russians for their war crimes against Ukrainian civilians. A second is to prevent the Russians from adapting our technology to use in future wars against civilians.

The Russian response will be to develop their own technology, but in most areas, Russian technology has been inferior to western, and the technology gap will be exacerbated by the ongoing exodus of Russia’s best technical minds. A second alternative is to import technology from other countries, especially China. Russian imports of Iranian drones and possibly Iranian ballistic missiles is an immediate example of this.

Let the Bastards Freeze in the Dark

Russia will fight the economic war by depriving the west of oil and gas and by trying to keep the price of oil and gas as high as possible. Russia’s strategy of being a plentiful supplier of oil and gas to Europe has been upended by the war. Russia’s shutting down and then sabotaging its own pipelines (the latter likely, but not yet confirmed) have marked it as an unreliable energy supplier, and Europe will never turn to it again. Russia’s response to the loss of its energy customers in Europe will be to try to find them elsewhere, especially China and India.

Russia is an active player in OPEC Plus and will exert pressure on the cartel to limit production and raise prices. Increased prices bring in more revenue because of the relatively inelastic short-term demand for oil. With the west now dealing with higher rates of inflation than experienced in the last 40 years, increases in the price of oil will contribute to the new inflation. Increased inflation reduces the popularity of political incumbents and spurs western central banks to use monetary policy (quantitative tightening to increase interest rates) to slow economic activity. From Russia’s point of view, the recent OPEC Plus initiative to cut production is a trifecta. It increases revenues for Russia, reduces the despised President Biden’s popularity just before the midterm elections, and helps to bring about a recession in the west.

If energy is a key battlefield in the economic war with Russia, there are short-term tactics and long-term responses the west can adopt. The US Government’s deployment of its strategic oil reserve is a short-term tactic to lower prices. Attempting to form a buyer’s cartel is another, though it is unclear how effective or enforceable this will be. Reducing dependence on Russian, or indeed any other sources of oil and gas is the best long-term strategy.

One key policy instrument in both the long and short term to reduce dependence on oil and gas is a carbon tax. A planned increase in the carbon tax becomes politically infeasible if the price of oil or gas has already increased enormously. A carbon tax raises revenue but then redistributes it through per capita grants. A reasonable substitute for a carbon tax would be a tax on windfall energy industry profits. It too gives the government a source of revenue that could also be redistributed through per capita grants. The challenge to western governments is to establish and administer a tax on windfall energy industry profits and to work out its relationship to planned increases in carbon taxes. Whatever technical solution to this problem finance ministries develop must be sold to a skeptical public that is worried about inflation.

We face enormous policy challenges in preventing the Russian energy war from weakening our economies and from achieving our climate change goals. We should prepare for a long war.

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