Crunch Time for Europe’s Economic Sanctions

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By Jean Pisani-Ferry

In 2003, the conservative US pundit Robert Kagan famously wrote that Europe “is turning away from power; it is moving beyond power in a self-contained world of laws and rules.” After Russia invaded Ukraine in late February, the European Union decided that it was time to prove Kagan wrong. The EU has mobilised economic power, at least, against Russia’s military aggression, and deployed an array of monetary, financial, trade, and investment sanctions.

Europe’s swift and muscular reaction has rightly been hailed. The shock effect of freezing much of Russia’s foreign-exchange reserves was spectacular. But as the war continues, will the sanctions remain effective? And if their impact weakens, as seems likely, will the EU be able to step them up in a meaningful way?

A worrying sign is that after the EU’s decision on 15 March to ban imports of steel and exports of luxury goods to Russia, there were no further announcements at the leaders’ meeting on 24 March. Europe will not force Russian President Vladimir Putin to back down by depriving Russian oligarchs of the latest Ferraris and Louis Vuitton handbags.

EU leaders cannot evade the question of possible further sanctions. On 7 March, a few days after Russia’s reserves were frozen, 100 rubles were worth just $0.72, down from $1.30 in early February. But by 27 March, the ruble had recovered to $0.99. As Robin Brooks of the Institute of International Finance has emphasised, Russia is accumulating massive current-account surpluses and is thus en route to rebuilding both its reserves and its import capacity.

Economic cost for Europe

Banning Russia’s central bank from accessing its reserves was costless for the EU. But virtually any additional steps – reducing imports of oil and gas, banning a wider range of exports, or telling European firms to withdraw from Russia – would entail an economic cost for Europe.

That is why the EU is dithering. Policymakers are discussing an energy embargo or a tax on Russian oil and a gradual reduction of gas imports. But German Chancellor Olaf Scholz remains opposed, warning that abruptly cutting Russian energy imports would plunge Germany and Europe into a recession.

How large would the cost of tightening the screw on Russia be? The war in Ukraine has already darkened the economic outlook. The OECD recently estimated that, assuming prices of energy and commodities remain elevated, eurozone growth will be reduced by about 1.5 percentage points, and inflation will rise by two percentage points. Other assessments are more benign, but only because they start from less adverse assumptions.

These negative adjustments look big, but two caveats apply. Until the war began, growth in 2022-23 was expected to be buoyant; lowering a 4 per cent growth forecast by two percentage points is not the same as cutting a 1 per cent forecast by that amount. And the OECD rightly observes that Government policies – such as targeted fiscal support to the worst-hit low-income households – can help cushion the shock and reduce the growth shortfall.

The more difficult question is how much it would cost Europe to reduce and ultimately eliminate its dependence on Russian energy – or, equivalently, to withstand a Russian export ban. The data are frightening: In 2019, the EU imported 47 per cent of its coal, 41 per cent of its gas, and 27 per cent of its oil from Russia. And while coal and oil are global commodities, implying that one supplier can largely be substituted by another, gas flows depend on the infrastructure of pipelines and liquefied natural gas terminals.

Currently, Russia can hardly export its gas elsewhere than westward, whereas the EU’s greater substitution capacities put it in a stronger position than its adversary. But shifting away from Russian gas will not be painless. Both protagonists are thus playing a game of chicken.

Payments in rubles 

On 23 March, Putin announced that Russia would accept payments only in rubles for gas deliveries to ‘unfriendly countries’, including all EU members. This is probably first and foremost a ploy to force the EU to violate its own ban on transacting with the Russian central bank. But it is also a way for Putin to signal that Russia is prepared to stop exporting gas to Europe and to dispense with the corresponding revenues.

Is the EU ready to call Putin’s bluff? Past experience, such as the sudden closure of nuclear plants after the 2011 Fukushima disaster, suggests that the economic system can adapt quickly to disruptions. In the case of Germany, a widely cited paper by Rüdiger Bachmann and others puts the overall cost of an abrupt stop to Russian energy imports at between 0.5 per cent and 3 per cent of GDP. Results for the EU as a whole appear to be similar, but the impact on countries like Lithuania and Bulgaria would be much greater.

Today’s uncertainty understandably makes European policymakers nervous. But an energy embargo is now within the range of possibilities for the immediate future. Because the West has invested its entire credibility in the effectiveness of economic sanctions against Russia, irresolution can quickly become a fatal weakness. The EU has little time left to prepare.

The concern is that, instead of drawing up contingency plans for adapting the European energy system, developing new collective energy-security mechanisms, and supporting the worst-affected member states, European Governments started by rushing to clinch individual supply deals with Middle East producers. The lack of common purpose was striking. One hopes that the agreement reached on 25 March to organise joint gas purchases will trigger a change in attitude.

Europe’s leaders should make it clear to the public that they cannot defeat an adversary ready to endure a 20 per cent drop in national income if Europeans are not willing to risk a 2 per cent decline in their own. But the same leaders who recently dared to lock down their fellow citizens to combat Covid-19 are now unwilling to tell them to drive a little slower to conserve fuel.

Europe’s economic conflict with Russia is entering a hazardous new phase. The risk of failing is too big to be taken.

Jean Pisani-Ferry, a senior fellow at Brussels-based think tank Bruegel and a senior non-resident fellow at the Peterson Institute for International Economics, holds the Tommaso Padoa-Schioppa chair at the European University Institute. 

(Project Syndicate)