Global supply shocks are historically rare events. All the more extraordinary to have two such shocks in quick succession - the second arriving even before the first has entirely faded away. That is what the world now experiences in the form of the Great Pandemic followed by the Great West-Russia economic war. The most visible symptom of the supply disruption is the sky-high price of energy and a range of other commodities.
What Is the Effect of Sanctions?
The waging of a long and all-out military war usually, if not always, exerts a toll in terms of surging prices. But what about economic war waged through Western sanctions by states not simultaneously engaged in direct military conflict? The laboratory of history for such warfare is small. Indeed, there is no experience with which usefully to compare the West’s economic war against Russia in the present. There are grounds to think that there will be serious long-term price-inflation-fueled damage on the perpetrators. (The consequences of price increases for the country on the receiving end of sanctions is a subject for another day).
Let’s take one step back to consider what is new about the nature of this economic war.
First, it started as a clear threat by the USA and its main European allies. Spelled out in all its menacing detail, albeit with some ambiguity at the start, aimed at deterring a Russian invasion of Ukraine. It failed in that first objective. Both the economic war and the military war are now in a “dig-in” phase. A snapshot of the dominant view at present in the marketplace is that the Russia’s military campaign will reach a “permanent ceasefire stage” long before the effective end of the economic war.
Sanctions Are Very Broad
Second, this economic war’s scope is unbounded. The campaign plan in the present dig-in phase is apparently to “close down” large parts of the world’s seventh- or eighth-largest economy (around the same size as Canada’s). There is no historical parallel. Yes, in the mid- and late 1930s, various sanctions were imposed against Italy, Japan, and Germany by Western powers acting separately. But these sanctions did not prevent Polish troops finding in the German onslaught of September 1939 that most of the German motorized transport had been made by GM and Ford; and they did not stop the Bank of England delivering the Czech holdings of gold in London to the Reichsbank (the central bank of Germany, now the “protector” of Prague) as late as spring 1939.
Much of the World Remains Neutral in Terms of Trade
In considering scope, though, we should recognize that in the West’s economic war against Russia, much of the world is neutral - including China, India, Latin America, and Middle Eastern nations. So what appears initially as a cutoff of trade and financial intermediation might quickly mutate into something more like geographical diversions on a large scale. The media is understandably full of the workarounds which Russia might find, whether front companies in the neutral world; financial institutions there who can hide its operations from or are untouchable by US regulators and prosecutors; or the use of gold, crypto, or yuan for making international payments.
There has been no statement of economic war aims—whether regime change in Moscow or Russian military withdrawal from Ukraine. But we can assume that an armistice agreement in which Russia takes over large corridors of Ukrainian territory in the East and South would not bring the economic war to an end.
In the meantime, we should note that Russia’s rearranging of its trade and international business relationships away from North America and Western Europe to the neutral world would amount to a substantial negative demand shock for Europe (most of all Germany and the eastern European countries). That comes on top of the negative effects of the energy shock (which to some extent the neutral world avoids, thanks to Russian energy supplies diverted to them at far below Western market price).
Direct Negative Economic Impacts of Sanctions in the West
In assessing the price-increase implications of the dig-in and mutating economic war, a starting point is the efforts of governments (together with their monetary authorities) to work against the negative economic impact on much of the voting public. The squeeze on real incomes from energy and wider commodity price hikes, and the loss of incomes and employment (as in Europe) caused directly by loss of export business and other joint economic activity emanating from Russia, hit overall prosperity. And there is the possibility that the waging of economic war will become the catalyst to some unwind in asset inflation. That unwind can add to perceived present economic woes. Hence, the monetary authorities in the West might well back away from “policy normalization.”
One could say that the recessionary influence of the events described would provide some breathing space for normalization to be delayed. But in the economic rebound after the shock, we can well imagine that the recessionary interlude will mean the monetary authorities are even more prone to delaying and treading gingerly when it comes to the subject of normalization. There is so much potential for the authorities to overreact to the recessionary downturn and asset deflation.
The danger of the economic war in terms of price growth extends further. The waging of economic war enhances the statist nature of Western money.
In the pursuance of efforts to dislocate and indeed disable financial transactions by Russians, Western governments and their armies of regulators intrude even further into every aspect of the payments process and financial transfers. Surveillance capitalism advances further. The ostensible justification is to ensure that clandestine operations are not taking place with banned Russian counterparts. The intensification of these intrusions works against the right to privacy and stifles competition including innovation.
Gold and Bitcoin
Anyone who was optimistic prewar about the dawning of a new age of monetary competition that would discipline the monetary inflationists can think again. One big plausible enabler of competition, a spread of blockchain technology (such as financial institutions issuing their own digital coins, whether in dollars or gold), is now stymied by the economic war. Surely, the Russian would-be evaders of sanctions would gain from this; therefore, it is forbidden.
One lesson of the continuing economic war, certainly not new, and well known to Moscow before the conflict, will likely loom large in investor consciousness. Outside the international banking system, gold bars and coins, sales or purchases against cryptocurrency of which are possible for the purpose of effecting transactions, are safer than US Treasurys.
We might therefore expect global demand for Treasury bonds, hitherto regarded as the premier reserve asset, to become much less robust, at least on the part of large present dollar-reserve holders. Higher yields on Treasury paper would weigh on US public finances. An increasing debt servicing cost would mean a political climate even more favorable to the Fed holding down the real costs of borrowing by stimulating monetary inflation.