1 year ago, an alliance of democratic states, led by the G7, responded to Russia’s invasion of Ukraine by declaring economic war on Russia.

An economic war that wasn’t fought with weapons. But, with sanctions that would in the words of European commission president von der Leyen be imposing:

massive costs on Russia. costs that will further isolate Russia from the International Financial system and our economies.

And, the goal of these sanctions was then:

to cripple Putin’s ability to finance his war machine

But, now, Putin’s war machine is the one preparing for new offensives while the G7 backed Ukrainian army is reportedly running out of resources.

So, after 1 year, why did sanctions against Russia fail to live up to expectations? To answer that question, we first need to recap the major sanctions, and countermeasures of the economic war. Then, we can judge how much sanctions have actually hurt the economies, currencies, and war efforts of both Russia and the Allies. We can then use this to extract some key lessons learned, which will in turn, help us to assess what the next phase of the economic war might look like.

So, let’s go back in time to right before Russia’s invasion.

1 What Happened?

Just before the war, despite quite a few sanctions already being in place since Russia’s invasion of Crimea in 2014, there was still a heavy trade dependence between the European allies and Russia.

And, yes, you have seen that right, while the alliance of countries that sanctioned Russia for a large part consists of giants like Japan, South Korea, and the United States., I will mostly focus on European countries because they had the tightest integration with the Russian economy.

When it comes to trade, you could roughly say that Europe relied on Russia for raw materials, and, energy in the form of oil and gas. At the same time, Russia depended heavily on Europe for medicines, as well as advanced machinery and microchips.

On the financial side, European banks **financed** the development of technologically advanced industries, notably, for the exploration of difficult to reach energy fields. At the same time, many of Russia’s oil profits were invested back in European financial markets, as well as in real estate and prestige projects such as football clubs, especially in the UK.

When it comes to the exchange of people between these economies, Russia’s oligarchics famously loved to spend their energy profits on London real estate and yachts in the Mediterranean.

Although, since Russia’s invasion of Crimea in 2014, this trend had already started to reverse somewhat. What’s more, from this point onward, migration from Russia to Europe accelerated. People even called it a braindrain as hundreds of thousands of highly educated young Russians emigrated to work and start businesses in Europe and beyond.

At the same time, thanks to its gigantic trade surplus, Russia had assembled a 600bn Dollar war chest of foreign exchange reserves. The idea was that, if Russia was to be sanctioned, it’s central bank could use these reserves to buy Rubles and thereby prevent it from collapsing.

To avoid losing these reserves, Russia’s was keen to minimize the number of Western currencies in it’s war chest. However, because of how dominant the Dollar and Euro were, a large part of Russia’s war chest still consisted European assets. You see, given their dependence on Russian energy, Putin had gambled that the Europeans were far less likely to mess with these reserves than the Americans.

So, with a full war chest to defend the Ruble, Russia began it’s invasion of it’s sovereign neighbor, Ukraine:

<clip invasion, “Special Military Operation”>

In response, the allies announced two types of sanctions against Russia: financial sanctions, and trade sanctions.

Let’s focus on financial sanctions first. These types of sanctions severely limited the ability of Russia’s state, central bank, private banks, and elite individuals to transfer, borrow, and hold money through the Dollar dominated global financial system.

And, based on the success of financial sanctions against Iran in 2010, the hope was that Russia’s currency would quickly collapse, leading to sky high inflation, an unhappy population, and then, hopefully, a Russian retreat.

Of course, Russia’s war chest stood in the way of that. Therefore, in an unprecedented move, Europe, Japan, and the U.S. moved together to freeze over 60% of Russia’s war chest. In practice, this meant that, while Russian banks and it’s central bank still technically own various deposit accounts and bonds in Allied bank accounts, they can no longer use them to stabilize the Ruble.

In response, both Russian and non-Russians tried to get their money out of Russian banks and financial markets as quickly as possible. This caused the Ruble to loose more than 40% of it’s value, which in turn led to sky high inflation in Russia. Around the same time, thousands of Russians started protesting the war.

So, at that point, financial sanctions seemed to work according to plan, just as they did in Iran in 2010.

And, if that wasn’t enough, Russia’s elites were hit hard by financial sanctions that were specifically targeting their European bank accounts, town houses, and gigantic yachts. This, made for some pretty spectacular news stories like this one.

<Friday … yachts seized>

But, did sanctioning Russian elites actually make a difference?

You see, the hope of Allied countries had been that, even if the people wouldn’t be able to convince Putin, then Russia’s rich oligarchs would surely pressure him to change course. However, what I’ve read and heard from experts on Russia is that, since these elites get all their riches and power from the regime, they are too dependent on Putin to actually challenge his authority. Of course, they were hurt tremendously by allied sanctions. However, only very few elites ended up speaking out against Putin. And those who did, subsequently were moved to less influential positions, died mysterious deaths, or, understandably, fled the country.

The response of the Russian government to the people protesting people in the street was equally brutal, arresting thousands of protesters. In March, Russia’s government even signed a law that stated that those that spread what the state deemed to be “fake information” could face up to 15 years in jail.

So then, rather than change Putin’s mind, hundreds of thousands of Russians decided to vote with their feet, and flee the country.

This is already where we see that, while sanctions do have a big impact, they don’t always work as intended. What’s worse, now it was time for Russia to start making its own moves in the economic war****.****

First, they employed financial countermeasures when, in response to people trying to get their money out of Russia, Russia’s central bankers raised interest rates, raising the attractiveness of the Ruble, and, more importantly, they imposed strict capital controls, limiting the ability of people to actually sell Rubles.

Next, Russia basically imposed trade sanctions on Europe when it sharply reduced the flow of natural gas to the continent. Now, because Europe mostly relied on gas through these pipelines, it wasn’t easily able to replace it with gas from other providers. Therefore, the Russian energy squeeze caused the price of energy in Europe to increase tenfold, leading to sky high inflation and a dire cost of living crisis. This then lead to big anti-war protests in Europe, rather than in Russia.

At the same time, soaring energy prices meant that, even though Russia sold less gas, it made more international money than ever to convert into Rubles, and this, along with the restrictions on selling Rubles meant that the Ruble not only recovered, it became stronger than ever.

Not surprisingly, around this time, the allies increasingly emphasized that the second type of sanctions, trade sanctions, were actually the important ones and that they were, in fact, working.

Remember that Russia relied on the Allied nations for high-tech chips and machines to make and maintain advanced weapon systems?

Well, many of the Allied trade sanctions were precisely aimed at preventing these goods from reaching the Russian economy. And, in the second half of the year, they indeed seemed to be working. While Russia stopped publishing it’s import statistics, export statistics from other countries revealed that Russian imports were way down. Then, over the summer, Russia’s war efforts stalled and while it is hard to separate the impact of trade sanctions from Russian military blunders or Ukrainian successes, increasingly, there were reports that Russia’s army was indeed suffering from micro-chip and manpower shortages.

So, at this point it seemed that, trade sanctions were doing real damage to both the Russian and European economies. However, this was before both economies started adapting to the sanctions.

First, under the name of the Repower EU plan, Europe surprised everyone by rapidly reducing its dependence on Russian energy in three main ways. First, it managed to build liquefied natural gas (or LNG) infrastructure off it’s coasts at unprecedented speed. This allowed it to almost completely switch to alternative gas suppliers such as The United States and Qatar. Second, for some of its energy needs, Europe was able to switch to alternative sources of energy such as coal, diesel, and renewables. Finally, and really importantly, Europeans were able to reduce their energy demand in relatively painless ways by improving the efficiency of, houses, machines, and business processes and also like we did at my place by just by reducing the temperature in their buildings by on average 1 degree Celsius.

Then, helped by one of the warmest years ever, both energy prices and the Ruble started to fall again and Europe felt confident enough to start imposing sanctions on Russia’s energy sector. This was important because: as research analyst Edward Fishman said “trying to impose significant sanctions on Russia without touching its oil sector is sort of like trying to master Russian literature without reading Tolstoy”. So, after diversifying away from Russian oil, the Allies imposed a price cap of 60 Dollars on Russian oil, meaning that any ship that transported Russian oil above that price couldn’t be insured by the allied insurance companies that dominate the market.

But, while initially the price cap seemed to work surprisingly well, it recently became clear that Russia has assembled a so-called shadow fleet of tankers that allowed Russian oil to bypass sanctions on an industrial scale.

To make matters worse for the Allies, Russians also reduced their dependency on Western goods. This first way it did so was through a process that famous economists Branco Milanovic has dubbed ************technologically regressive import substitution.** With this he means replacing imported goods with “inferior, old-fashioned domestic substitutes”. ************F************or Russia, this meant that, yes companies didn’t have access to advanced Allied machinery anymore. But, when, for example, Russian firms could no longer replace their Japanese engines in their forklifts, they just installed old engines from Belarus.

Sure, these are inferior products. So, this will reduce the efficiency and therefore competitiveness of Russia’s industry in the long-run. But, … it works quite well in the short-run, making Allied trade sanctions much less effective.

The second way that Russia dodges trade sanctions is through alternative supplier. Recent reports indicate that China is now providing many crucial goods such as microchips to Russia. Third, thanks to a gigantic smuggling industry operating via Russia’s neighbors, Allied chips are once again showing up in Russian missiles recovered in Ukraine.

This all has weakened sanctions so much that Russia is now apparently importing more microchips than before the war started.

And, that brings us to today, after an initial shock, trade and financial sanctions from both sides are now far less effective. That being said, Europe is still dealing with energy prices that are uncomfortably high and, at the same time, Russia’s economy is far less competitive when it comes to anything other than exporting raw resources than it used to be.


Who is winning the economic war after a year?

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Who is winning the economic war after a year?

Well, to assess this, we need to keep in mind that, the original goal of sanctions was to stop or reduce the war effort by creating economic pain and inflation.

So, let’s start by looking at inflation. When looking back at the year, it became clear that both economies were hit by sky high inflation that then later subsided. But, whereas inflation in Russia doubled from 6,7% in 2021 to 13.7% in 2022, it nearly quadrupled in Europe, soaring from a low value 2.45% to a quite remarkable 9.2% in 2023

Of course, not all of this was due to the economic war. But, given that a large part of Russian inflation happened right after the Ruble crashed in March, and Europe’s inflation peaked right after Energy prices peaked, we can safely assume that the economic war played a major role.

So, if we look at the raw percentage increases of inflation, both economies lost the economic war in fairly equal terms. However, compared to it’s history of low inflation, the relative change was more extreme in Europe and therefore, I think, that on the inflation front, Russia lost a bit less.

But, what about GDP? First, let’s be clear that Russia’s economic performance really surprised both Western and Russian analysts. The latest estimate I read is that, corrected for inflation, the Russian economy shrunk by 2-4% last year. That is much much better than international estimates of -15% as well as leaked Russian estimates of -8%. What’s more, current IMF estimates for Russia are that it will grow by 0.3% next year, which is more growth than, for example, it expects for Britain in 2023.

Similarly, against Russian expectations, Europe’s gas starved economy is also predicted to grow by 0.3% next year, and that is after it narrowly avoided a recession in 2022. So, on average, while it hurt, Europe’s economy still did better than that of Russia and likely has a rosier future, given that hundreds of thousands working age Russians left the country or died on the battlefields of Ukraine.

So, on average, I’d give this one to Europe, even though, Russia’s economy has proven surprisingly resilient.

Finally, when it comes to the war effort, it is clear that sanctions failed to cripple the Russian war machine. Similarly, Russia’s energy weapon did not discourage the Europeans from imposing sanctions on Russia and supporting Ukraine, as the Russians had hoped.

So, in this key category, I’d say that the result is inconclusive.

And, therefore, I do understand that people would say that sanctions have been a failure. After all, even though Russia’s economy was hit the hardest, allied sanctions did not achieve their ultimate goal of stopping Putin’s war machine.

But, let’s not forget that the economic war had a gigantic impact on the lives of everyone in the form or inflation, loss of property, and by blocking the movement between these once so integrated economies. What’s more, many advocates of sanctions believe that, even if they didn’t stop the war and thus failed, sanctions have still sent a powerful signal that invading your neighbors isn’t without cost.

So, now that we have discussed the complete sanctions timeline and end-result, here are my

five take-away lessons about the economic war.

Lesson 1:

Assets held in the Allied financial systems are no longer completely safe.

But, okay, at the same time, you could say that for most countries, they are still completely safe, as long as you don’t invade your neighbor, which isn’t that hard.

Anyway, the second lesson is that Russia has shown us that

financial sanctions can be countered by raising interest rates, and imposing capital controls, as long as you run a sizeable trade surplus.

The third lesson, was taught to us by the Oligarchs, and that is that

financial sanctions against individuals don’t pressure the government, if elites have more to lose from their government than from allied sanctions.

My fourth lesson is one that Europeans and mostly the Germans have now learned that

it is no longer the best strategy to heavily rely on one trading partner for crucial supplies that are difficult to replace such as pipeline gas.

Finally, as both Russia, with it’s energy weapon, and the Allies, with their trade sanctions, are now finding out:

The longer trade sanctions are in place, the more they will be avoided, either via reduced demand, technologically regressive import substitution, alternative suppliers, and / or smuggling operations.

Although, it should be noted that, in the long-term sanctions can still make an economy like that of Russia much less competitive on the global stage.

So, yeah, then what are the implications of all of this for

The Next Phase of The Economic War

Well, for a large part that depends on the actual war in Ukraine. If Russia stops fighting, some of the worst sanctions could be eased. Although, the Allies haven’t really given Russia a clear indication that, if that happens, they will actually be lifted.

So, if sanctions remain in place from both sides, we would likely see a stabilization scenario where things slowly return to normal. But, where energy prices remain elevated in Europe while trading with Russia remains difficult.

Still, that scenario is much better than a complete escalation of the economic war. Something that could potentially happen if China would come to believe that, given that Russia’s economy was surprisingly resilient, it can also handle Allied sanctions and decides to invade Taiwan. Sanctions against China would be way worse for everyone because the Chinese is much bigger than that of Russia.

So, with that context, I think it makes sense that more and more economist that I follow are saying that we could already be in a **********second cold war**********. And, if that is correct, then we could look at the first cold war to get an idea of what happens next economically: the emergence of separate trade and financial systems that are dominated by three blocks. The first block consists of China and it’s allies, the second block consists of the United States and it’s allies, and a third block consists of countries that are trying to do business with both sides.