Economic Sanctions on Russia

>> Steven Davis: Two questions, how have economic sanctions on Russia affected its economy and its war fighting capabilities? More broadly, when are economic sanctions likely to be effective, ineffective, or downright counterproductive?

Welcome to Economics Applied, a podcast sponsored by the Hoover Institution. My name is Steven Davis, joining me today are two enterprising and highly accomplished economists.

First, Oleg Itskhoki is a professor of economics at Harvard. He previously held faculty positions at UCLA and Princeton. Among his many other honors, he is a Fellow of the Econometric Society and a recipient of the John Bates Clark Medal. Elina Ribakova is a senior fellow at the Peterson Institute for International Economics and director of the International Affairs Program at the Kiev School of Economics.

She has held several leadership positions in her career, including as managing director and head of the Europe, Middle East and Africa Research at Deutsche Bank in London. Welcome to both of you.

>> Oleg Itskhoki: Thanks, Steve, good to be here.

>> Elina Ribakova: Thank you so much.

>> Steven Davis: So, after Russia launched a full scale invasion of Ukraine in February 2022, a coalition of countries, including the United States, imposed new economic sanctions on Russia.

There had already been some sanctions before, but a host of new economic sanctions. And you assessed the overall effects of these economic sanctions on Russia in a recent article for the Brookings Papers on Economic Activity. And you also sketched out the broader, I think, lessons and messages from economics about when sanctions can be effective or ineffective or counterproductive.

So to get us started, give us an overview of economic sanctions on Russia in recent years. What types of sanctions, who imposes them, how are they enforced, and also what are their objectives? So, who wants to take a crack at that?

>> Oleg Itskhoki: Elina is in the best position to give an outline of the whole history of sanctions in Russia.

>> Steven Davis: Okay, let's do that and we'll get into some of the details later. But let's give the audience an overview so that they'll have kind of an informed sense for the rest of the discussion.

>> Elina Ribakova: Excellent, so I won't start with Jackson-Vanik in the 70s, but I will give you the more recent history.

So just to give you a perspective, sanctions or tools of economic statecraft have been used historically for decades, if not centuries. So that by itself is not new. What is new is using sanctions on a highly integrated economy in this sort of post Cold War era of trying to achieve certain objectives.

So for Russia, it is started in 2014. One could arguably say that 2014 sanctions were the warning shot. They were painful, but the message was, if you don't stop here, wherever that was at the time, Crimea, we're gonna go on further. So let's not forget that, then the sanctions in 2022.

What is meant to show the cost? You went further, this is the cost. A lot of people who have joined the sanctions discussion more recently, they focus too narrowly on this 2022 period only, right? And then what exactly has been imposed? Most successfully, financial sector sanctions. But then we also expanded into the new, less sort of familiar territories like the oil price cap, limitations on oil markets.

And export controls, prohibiting Russia from getting access to certain critical components.

>> Oleg Itskhoki: What we do in the paper is really separately look at the 2014 sanctions and 2022 onward sanctions. And one can make a case in retrospect that 2014 sanctions were successful in really buying the time, right?

They were a warning sign, they were quite impactful. They were mostly financial sanctions. Russia was very integrated in the international financial market at the time. They gave time both to Russia and to the West. Russia did use that time to wean itself of the integration into the Western financial sanctions.

Europe and the US to a lesser extent, took advantage of the time. And in particular, Europe didn't wean itself from its reliance on energy purchased from Russia, right? But if you in retrospect see it as buying time, those sanctions were successful. 2022 was very different, that's already full scale invasion.

And these are sanctions that are much larger in their scope and much more costly as well for the Western countries that impose that. And they've been more of a mix bag exactly for those reasons.

>> Steven Davis: Okay, so I just wanna make sure I understand. So your view is that the 2014 sanctions, while they didn't deter additional aggression by Russia against Ukraine, they delayed it, is that right?

>> Elina Ribakova: Absolutely, absolutely.

>> Steven Davis: Okay, all right, so then, yes, it bought time for Russia, that's clear. And you say, as you point out, about time for, let's call them Ukrainian allies and friendly states. Maybe allies is too strong a term. But it doesn't seem to me that the United States or Europe used that time particularly well.

They certainly didn't do much in the way, or not that much to do Ukraine arm itself militarily and prepare for or deter further Russian aggression. So in that sense, I see how they could have been more successful. I'm not so sure they were in practice.

>> Elina Ribakova: Maybe I'll just jump in quickly on the 2014 versus 2022, the state of Ukrainian army.

I think that did change meaningfully. I think in '14, the Ukrainian army would have not been able to hold back Russia. We're now more than two years into the war. And of course, with the support of the friends, maybe allies at times, we have bigger success. So yes, it's not absolute success, but I think it is still an improvement.

>> Steven Davis: Okay, well, yeah, so I take the point there that I think the Ukrainian military's response to the Russian aggression since 2022 and earlier has been remarkable and extraordinary in many respects. I didn't mean to implicitly question that. I'm really criticizing the United States and some of the Western European economies that seems to me didn't actually prepare very effectively.

Nor did they take sufficiently aggressive steps to deter Russia from further aggression.

>> Oleg Itskhoki: This is a very fair point, right? So what happened during this period was really fragmentation that happened in the financial system, that Russia relied less and less on foreign funding. It de-dollarized, which was a longer term process, but it accelerated with the financial sanctions in 2014.

So it neither had external debt nor had a lot of dollarization in the Russian economy by 2022, which made it much more robust to the ensuing wave of financial sanctions. At the same time, Europe stayed remarkably reliable on Russian energy by the beginning of the war. If you want to identify another failure or missed opportunity, right, this was the period of extremely low military expenditure.

Falling fast military expenditure around the world, including in the US and historically very low military expenditure in Europe. And both Europe and US in that sense came unprepared as well. And I guess this relied on the sort of belief that Russia would not go for a full scale invasion, which obviously in retrospect-

>> Steven Davis: Yeah, so there's a couple really, really important points in what's just been said, I wanna draw it out. First, I'll put it in different language. I think to some extent Western Europe and the United States have been living in this fantasy land that land wars on Europe were a thing of the past and just wouldn't happen again.

So why bother to really prepare for them because it's expensive? But the second point is more about economics and that is because Russia did have so much time to prepare for the anticipation of further sanctions if they were to make more aggressive moves than they already had before 2022. 

They were able, as you said, to robustify their economy against these sanctions. That's a broader aspect of sanctions and there's two sides to it. The anticipation of sanctions and the appropriate steps by target of the sanction gives the country a chance to deflect and mute the consequences of those sanctions.

And that's a kind of substitution response, you used de-dollarized their economy. But there are many kinds of substitution responses an economy can make. That also happens after the fact. After sanctions are imposed, the target country will make a number of attempts to adjust to that. So sanctions often turn out, I'm not saying they are in this case, we can get into that.

But they often turn out to be of less effectiveness over time simply because the target responds.

>> Elina Ribakova: You both are exactly nailing it, was the comments, I mean, we are all, including the US and Europe are complicit in helping Russia adjust. We saw this sort of fortress Russia emerging and at the same time we still had a lot of investments going into the fixed income in Russia, although certain sectors were off limits.

But if you remember, Russia did fiscal adjustment but at the same time it still needed a lot of external financing for its fiscal. So it's decided what is the best way to attract temporarily foreign investors is to have this inflation targeting, offer them positive real rates while in the meantime we're trying to squeeze our fiscal and reduce our alliance.

But we having the bridge financing from the west to continue doing what we want. At the same time, Europe continued to rely heavily on Russian energy, as you pointed out. So yes, so this fortress Russia that has emerged since 2014. They've seen a lot of telegraphed messages, including on Swift, right?

And they prepared for them. So we have alternative payment systems, we have alternative messaging systems. We require foreign companies like Visa and MasterCard to continue through the domestic payment system, not an independent payment system. So we've done a lot of little steps which have sort of converged to this fortress Russia which undermines some of the sanctions taken in 2022.

>> Oleg Itskhoki: And I just wanted to make two points related to this. So the first one is, if you can rely on overwhelming sanctions response in case of a land conflict, then you can keep those things largely off equilibrium, right? And so that was sort of the premise that those things cannot happen because there was an anticipation of an overwhelming response from the West.

Clearly it didn't happen in '22, it was a response that imposed a lot of costs, but it was not overwhelming enough to keep those things off equilibrium. And so once it's not off equilibrium, you transition to a very different kinda world where these conflicts happen. They happen with some regularity, they require response, and the response is very costly for all parties involved, right?

When you can keep it off equilibrium, you can rely on a fairly low cost of enforcement.

>> Steven Davis: So just for the non-economists in our audience, by off equilibrium you mean the prospect of something is so threatening, so alarming, so costly that you don't actually go down that path?

Yeah, it's something. So that's successful deterrence.

>> Oleg Itskhoki: Something that's not supposed to happen and you deter it by promising credibly an overwhelming response. And that overwhelming response didn't happen in '22, which makes these things possible to happen now. And the West needs to grapple with the fact that those types of conflicts can arise.

And it's a very costly situation now for both the countries involved in the conflict and for the Western coalition that needs to impose sanctions. Now the second point is that trade sanctions are inherently very costly. They rely on curbing the trade, which is presumably by revealed preferences, is mutually beneficial.

And so if you're dealing with a large country, and Russia is a rather large country in a number of markets, it is costly for the Western coalition to impose those trade sanctions. Financial sanctions are different, they're much less costly to impose because most of the world relies on the Western financial infrastructure.

And the West can threaten credibly to exclude those countries from using that infrastructure. But of course, if countries have the time to prepare, the costs of that are much lower. And that was exactly the situation of 2022.

>> Steven Davis: Right, let's take them separately cuz as you already pointed out, they're quite different in their character, but also in their consequences.

So with respect to trade sanctions, my very simple way of thinking about it is, trade sanctions are costly for the target, they're costly for the country or coalition of countries that imposes them. And then third, what often gets left out of the discussion is they can often benefit third parties.

And that's relevant especially because why? Because you cut off your supplies to the target country and other countries that aren't part of the coalition and aren't willing to go along step in. So we've seen that play out very clearly. In the case of the sanctions on Russia, it means China gets more oil and gas from Russia and at a discounted price.

It's played out to the benefits of the Iranians, as I understand it, because they sell munitions to Russia. North Korea, presumably, according to news reports, is getting some type of support for advanced weapon systems in return for the troops and munitions that they're supplying. And the reason I emphasize that is because I think we can expect it to be a general pattern or a common pattern that if the United States and its allies impose sanctions on a country, in this case Russia.

That adversaries are likely to benefit because the adversaries are the one. And here I've named a few adversaries, Iran, China, and North Korea. The adversaries are the ones the least likely to go along with the sanctions in the first place. I wanted to get your reaction to that cuz I find it's often omitted from these discussions of the pros and cons of trying to impose sanctions, especially as you already pointed out on a big country like Russia.

It's big in the sense that it's got a lot of land mass, it's a sizable economy, but also it has many ways to be supplied by land and by sea that you can't really easily foreclose.

>> Elina Ribakova: Maybe I'll just start on that, you're bringing the issue of the third countries benefiting from sanctions that we're imposing.

And what Oleg has in his theory section is the great discussion about the size matters, right? Market dominance matters and whether we are able to physically get the large enough coalition or we have dominance of certain markets that prevent somebody catching up. Third country providing this equipment. So I think there's a very good example exactly on energy, oil, and gas, which is rather substitutable, especially oil.

And then they can ship it different direction. Gas is much more complicated, Gazprom is cooked. They have a hard time, China doesn't want the pipeline, this is another pipeline. Well, it's much harder to sort of move the gas around. So there, you're right. In some ways, we have maybe helped out China with more competitive oil market, but maybe left Saudis and somebody else in Middle East unhappy because Russia is now competing more directly there.

India has picked up a lot of benefits of this low oil price, but somewhat low oil price. On the export controls, it's very different. It is most that the technology is still very concentrated. The technology is concentrated in the US for the chips. Taiwan has the foundries, from a lot of the equipment that's concentrated in Europe and then South Korea, maybe Japan.

Iranian sort of weapons that are being sent to Russia, they're not Iranian really produced. That are still our weapons, our components that are being assembled and then shipped to Russia. So I think here the cry for the third country benefiting is not quite as accurate, mostly because, first of all, we have market dominance.

And second, many of our companies are not really fully complying with the sanctions.

>> Steven Davis: You say we have market dominance, but still, you're talking about how the Iranians are managing to get access to chips produced elsewhere and use it in-

>> Elina Ribakova: In the US, produced in the US.

>> Steven Davis: I know, but they're still ending up, I presume, in missiles and artillery shells and so on that then find their way to Russia. And I think it illustrates, even when you have market dominance, it can be difficult to choke off the supply.

>> Elina Ribakova: Absolutely, administration matters. I think we're different, one is policy design and another one is administration.

An we have designed policy without concern for the fact that we don't have administrative capacity at the Department of Commerce and many other places to actually implement this policy.

>> Oleg Itskhoki: Let me add two further points.

>> Steven Davis: Yeah, go ahead, Oleg.

>> Oleg Itskhoki: I think it's very important to realize that contemporary time is very different from, for example, 90s, 1990s, after the end of the Cold War.

The West had the dominance economically in 1990s, it was 80% of global GDP. We live in a very different world now. The Western countries now account for maybe 60% of global GDP. And I wouldn't overemphasize the economic role of Iran and North Korea, but instead, I would emphasize countries like India, Turkey, a lot of third world countries that actually are much bigger and act as hubs.

And so what happens, of course, China created economic lifeline for Russia in the first year of the war and was essential for relocation of trade flows. But then countries like India and Turkey picked up and they're sort of really neither allies nor adversaries, but these are the countries that benefited the most.

And like, what we show in our other work is, in fact, the biggest discounts on sale in oil went not to China, but they did go to India and to Turkey. And so these were the new customers that really picked up a lot of slack.

>> Steven Davis: Okay, so that point is well taken.

But there's a distinction worth drawing here, which is where do the economic benefits to the third parties flow in some aggregate sense? And as you pointed out, maybe India benefited more than anyone, possibly India or China, I guess, and Turkey benefited a lot. I agree with that point.

But it's also the case that the capacity of certain adversaries to create mischief in other arenas, and here I'm thinking primarily of Iran and North Korea, has been enhanced. This is my assessment, by the side effects of the sanctions that the US and allies have imposed on Russia.

And I don't think we wanna lose sight of that. It's not just about the direct cost to our own economies and the benefits that have flowed to some third parties that are neither adversaries nor close allies, as you point out. So the reason I'm stressing all this point is because I think of these as less obvious costs of trade sanctions in particular, that often don't get enough attention in the discussion.

>> Oleg Itskhoki: Yeah, go ahead, Elina.

>> Elina Ribakova: No, I think it's important nuance to keep in the conversation. What would be the counterfactual? So instead of Iran or North Korea trying to get access to Western components and shipping it to Russia, we would be shipping our components to Russia for the war equipment.

So that is also not a viable solution, right, I appreciate the nuance. The war has created this new alliances, the new access.

>> Oleg Itskhoki: So let me provide a counterfactual that I think is a meaningful one to have in mind, and this is not the world we live in.

So the counterfactual is there is a clear international framework for what behavior of different countries is off limits and requires an engagement of a broad coalition of countries, including China, including India, including South American countries. This would have been a counterfactual world where there is indeed a framework for imposing sanctions that a lot of countries subscribe to and they benefit from it because if the aggression is directed towards them, they know that they would be protected in a similar way.

Clearly, we live in a very different world. We live in a world of discretionary sanctions that are very piecemeal, where instead of having a broad coalition, you need to have enforcement. So what US Needs to do is a much broader enforcement, which is costly, but that's the result of not really having a robust framework.

75, 80 years after the Bretton Woods Institutions were established, they stopped working. And so there is a missing framework out there. And this is what results in a very high cost of enforcement.

>> Steven Davis: Right, I wanna add just two things to this discussion first. Yeah, I agree when I think this is the view of both of you that just supplying uninhibited the same kinds of components that go into munitions, for example, to Russia as we had before 2022 would have made no sense.

So that's not what I'm arguing. What I am arguing is I think we need to be realistic about the prospects of what trade sanctions can actually achieve against an opponent like Russia. And in my assessment, we can see if you agree, they are limited. And we should understand that ex ante, both in terms of how much degradation of the Russia's economy and war fighting capability we might anticipate from the past and further application of sanctions.

But also it speaks to the deterrent value of sanctions for a society like Russia. The second point I wanted to make, and this is when I think about, it's related to what Oleg just said. And I would add to it, part of this framework idea is, if you aren't going to play by the rules, and here violating the rules would be something like trying to change borders by force in Europe, which is what Russia has been doing in Ukraine.

That's a violation of the rules and you'll be excluded from the economic party, so to speak, in significant ways for a long time until you reform your behavior, and perhaps even longer than that. And so the goal is really in some extent to degrade the target of the sanctions, to degrade their ability to create mischief, not just in the near term, but I think over the medium and long term.

That's part of how I see the Russian sanctions, at least as long as Putin is in charge and maybe longer. Russia does not seem like it's willing to abide by these norms, these international norms that we had come to see as durable. And so we wanna undermine the performance of their economy and particularly its war fighting capabilities until they do so.

All of that is to lead up to, what's the most cost effective way to do that? And in Russia's case, I would have thought, and I wanna get your reaction to this, I don't know about it deeply. I would have thought that one of the main things we should have sought to do is, to facilitate the immigration of talented scientists, engineers, doctors, mathematicians and so on from Russia after 2022 if not before.

Some of that happened naturally, but we could have facilitated a lot more of it, and also facilitated, where possible, the immigration not just of these individuals, but their family members. And I just wonder, do you think that's a more effective way to degrade Russia's war fighting capabilities over the long term?

Because this does seem like it's a long-term problem. I have a strong opinion on that, which I'm happy to share.

>> Oleg Itskhoki: I think it just happened naturally, as you said, about million people have left. The other thing that you did mention is technology transfer. So, technology transfer to Russia stopped, it stopped largely in 2014, but even more so in 2022.

And China is in fact not willing to step in and provide the technologies. It's willing to provide trade, but it's not providing the substitute for the Western technologies. And so, this will have impact over the long term, if you look at Russian for example, age and population structure, it's in complete crisis, right?

It's a million people sent to war and a million people that left, in the age groups of the most productive, essentially young men, oftentimes with families when they immigrate. And this will have dramatic long-term consequences, the problem is that the war is in its third year, and this cannot have a fast enough effect.

And so, you have to really separate the long-term impact, and here I fully agree with you, that's a good long-term policy, from the short-term impact and the medium-term impact. The short-term impact is the financial crisis, and that just didn't happen in the first months of the war. The sanctions were not decisive enough in the first months

So then you are in the medium term, and the medium term is curbing the revenues, making it harder to finance the war. And the sanctions were eating off a fraction of those revenues, making trade more expensive. So, like making harder to convert the revenues and to purchase in the inputs that are necessary for the war, that's all been happening.

It's not at the scale that's decisive, right. And in that sense, yes if you evaluate it, did they stop the war? No, how significant are they in curbing the ability to finance that war? Well, they're quite significant.

>> Steven Davis: Okay, so Elina unless you wanna jump in, I'm gonna transition now to the financial sanctions, which Oleg had just referenced to some extent.

So, let's turn from trade sanctions, there's a lot more we could say about trade sanctions of course, but we've got limited time. So, let's turn to financial sanctions, and Zolok already hinted and please take us back to 2022. There was at least I think a hope and maybe even an expectation that the financial sanctions would trigger a crisis, a balance of payments crisis in Russia, an internal financial crisis, that didn't really play out.

So, let's please talk about that, and start by putting us, what did we realistically or what did some hope to achieve with the financial sanctions? And I guess we need to describe exactly what those financial sanctions are and how they work put those on the table.

>> Elina Ribakova: So, US has the dominance of the dollar and the dollar-based payment system.

So that's really the area where US has absolute dominance, especially when it's doing together with Europe, because then there are really no alternatives. It is hard to drive a country into balance of payments crisis that has double surpluses. So you have current account surplus, you have fiscal surplus, it's not Turkey.

Turkey is a wonderful example on the other side of the chart. So, if you look-

>> Steven Davis: And explain that for us, I agree, but explain why that's the case.

>> Elina Ribakova: So Russia entered 2022 with the surplus on the trade balance, and also fiscal surplus. That means it doesn't need external financing to cover either of those deficits, they're in surplus, they're accumulating reserves.

And this was a big shift for Russia or sort of deter, it was actually a plan which some of the international analysts misinterpreted as Russia being more liberal. And that's why you have this liberal block of economists responsible under tutelage of Putin and his office, to do inflation targeting and sort of do all the necessary reforms after post 2014.

To bring them into this absolutely modern IMF like style adjustment of the balance of payments and current balance of payments and fiscal surpluses. We thought maybe because that's our trying, puting turning liberal, more like the IMF. But in reality, maybe he had other plans nobody really knows what kind of plans were in his head, we're not gonna speculate on that.

But basically long story short, is that this turned Russia more into a fortress. So when you're pulling external financing from them, it doesn't hurt as much. In '14, actually it did hurt, they repaid more than $250 billion in just a year and a half, this is massive even for Russian standards.

The total external gross outstanding debt was about $700 billion, and they had to draw it down, because of the financial sector sanctions in '14. In 2022, the situation was different, as Alex said, they already disintegrated themselves from the corporate side, from the borrowing on the international markets corporates were pretty deliberate.

And therefore, in addition to the government, corporates delivered, they were in a comfortable situation. That said, there is signaling effect, Sberbank, the largest bank in Russia, was sending special trucks to its regions, to be able to meet cash demand in ATMs, it was crazy. So if you look at the liquidity position of the banks versus the central bank, Russian banks usually had ample liquidity, meaning that they have so much that they actually save some money at the central bank.

That swung into a huge deficit, it is comparable to previous deepest shocks that we saw in 2008 and in other history. So the shock happened is just given the preparedness of the economy and the central bank, they could stabilize it fast enough.

>> Steven Davis: Yeah, thank you for that.

>> Oleg Itskhoki: To add one more thing to this description which nails it, is that you cannot separately think about the financial side without net experts, right? And so to keep it in perspective, Russian budget balance, could have stayed in balance at oil prices of $45 a barrel before the war.

The oil prices went up to 120, and then stabilized above 80. So at those oil prices Russia was just essentially printing cash every day from the 5 million barrels of oil that it exports every day. And so that more than indeed all the effects of the financial sanctions.

So we have a big question, can you really trigger a banking crisis in a country that, as Elina pointed out, has double surplus? But you make your job all that much more difficult if the country is running absolutely humongous trade surplus along the financial sanctions, right? And so what we learn from this experience is the combination of export controls, which restricts Russian ability to buy imports.

They really undo the effect of financial sanctions. To the contrary, if you combine financial sanctions with import restrictions from the western perspective that curb export revenues from Russia, that would have been an altogether different story. But that was exactly what was too costly to do for Europe.

>> Steven Davis: There's an important point there, but it's a little complex, so let's just draw it out further. So one of the ways in which financial sanctions can be used and were used in this case, to harm an economy is to prevent it from borrowing abroad to finance the purchase of goods from abroad. Okay so-

>> Oleg Itskhoki: Even more so, Russia accumulated a lot of foreign savings, and so the sanctions targeted a large fraction of those foreign savings that couldn't be used for example, for stabilization of the financial market.

They were under sanctions and the Russian Central bank was under sanctions.

>> Steven Davis: Right, I understood you the point you were making previously is that when you impose restrictions on Russia's ability to import goods from abroad, you are in fact, to the extent you're successful, also reducing its need to finance those.

>> Oleg Itskhoki: Absolutely.

>> Steven Davis: So what you're pointing out here, and you do this very well in the article, is that there is an extent to which some aspects of financial sanctions and some aspects of restrictions on Russia's ability to import actually work at cross purposes. Whereas export restrictions, restrictions on what we and what US and its allies export to Russia are more complementary to the financial sanctions.

I think that's an important point to understand that gets lost in the discussion of Russia's behaving badly, so let's just throw everything at them. Export restrictions, restrictions on Russia's ability to import, and financial sanctions. And they don't always all work together.

>> Oleg Itskhoki: Yeah, and to summarize this in the conclusion, in the end, what we advocate as the most advantageous policy mix is financial sanctions as much as you can.

Because they're actually fairly cheap to implement together with things that curb export revenues that can be used as a substitute for financing. Together with very targeted sanctions on specific sectors and inputs that they used in production instead of a broad sanctions on all imports of Russia.

>> Steven Davis: You said it much better than I did, thank you.

That was much clearer. So, you know, my overall-

>> Elina Ribakova: Maybe, can I just jump in very quickly?

>> Steven Davis: Yes, please do.

>> Elina Ribakova: On the financial sector I would add one footnote to that which I will hope emerge into whole literature, is the financial sector frictions. We, in our macroeconomic modeling, we tend to assume it away.

It doesn't really matter, maybe it increases three, four percentage points, maybe ten. We can sort of assume it away in the model. But in some cases, for example, payment systems, they can actually create a kink basically where you can't continue, it's a choke point. And I think there's a lot of effectiveness of financial sector sanctions in that by using them correctly you could effectively block trade.

Of course, it brings us back to the question of costly, we were maybe not ready to do that. That's why we didn't go so harshly. But there is that opportunity which I think is somewhat under researched.

>> Steven Davis: But I take it now you're referring to payment sanctions in particular, as opposed to a broader notion of financial sanctions which would include ability to borrow and lend.

>> Elina Ribakova: Exactly.

>> Steven Davis: So I guess in the limit, if you completely shut down the ability of a target economy to make use of payment systems, they're essentially reduced to barter or exchange.

>> Elina Ribakova: Exactly, and we have seen some of that effectiveness of US using secondary sanctions. And now China, UAE, Turkey, banks are stepping back and Russia is having a harder time to import some of these components because of the threat of the secondary sanctions from the US.

>> Oleg Itskhoki: And this gets at the topic of enforcement that what we learned is that trade is fairly easy to substitute. I think that was a big surprise, how fast the substitution happened. So when there is this massive price movement, countries are very quick to substitute. And policymakers, and perhaps economists as well, underappreciated the ability to substitute quickly.

But the other important thing is enforcement. And it's much harder and costlier to enforce trade sanctions, much easier to enforce payment system sanctions. And this is exactly the reason why combining the policy together with the payment system sanction as a way to enforce things is perhaps a most optimal way of doing it.

We've seen in the data that new intermediary traders have emerged for Russian oil, new intermediaries emerged for European goods that travel to Russia. But once the sanctions were really imposed on the financial system and the due diligence was put on the banks, this is when the sanctions start working a lot better.

But it took a year and a half to sort of internalize that.

>> Steven Davis: Okay, there's some subtleties here to consider, one of which is how challenging it will be and how challenging is it for current and perspective adversaries to develop alternative payment systems? I'm no expert in this area, but it appears that China has for some time been investing heavily in trying to create payment systems that aren't so tied to the dominant dollar payment systems.

And here we're talking about how international trade is invoiced. Everything from, I feel funny here telling you about this Oleg, cuz you've written on this extensively, but there's a set of interconnected aspects of the dollar dominance. It isn't just that countries invoice many international transactions in dollars, but all of the financing around that often tends to be in dollars.

The markets associated with that are much thicker, more liquid, hence it's cheaper to do it in dollars. Both foreign sovereigns and foreign corporates, when they borrow, they often do it in dollars, even if they're not doing anything with the US. Again, because the dollar denominated markets and all the auxiliary legal and financial services that are around that are tied to the dollar.

So everything is anywhere from more expensive to downright impossible to do in certain transactions when you step away from the dollar, have I got it basically right?

>> Elina Ribakova: Absolutely.

>> Oleg Itskhoki: I would like to-

>> Elina Ribakova: Go ahead.

>> Oleg Itskhoki: Yeah, I would just add very briefly to this that where we are in 2024 might not be a good predictor of where we will be three or five years from now.

But in 2024, this is a node that it's a complete choking point in the system. We don't fully understand why, but it's some combination of the use of the dollar and the payment systems and perhaps the messaging systems that really make having a spot rupee very different from having a spot yuan very different from having a spot dollar.

So in our models, we typically don't acknowledge that difference. We think if you have a spot exchange market operating in one country, there is perfect substitution. What we see, it's not the case of perfect substitution. How difficult would be to build alternative infrastructure in a year or two from now on?

Because clearly the adversaries of the US understand that that's the priority. So we don't know, but so far it has not happened yet.

>> Elina Ribakova: And that's why I wanted to bring into this research point here because we all need to focus on it differently, not just people working.

Use of the dollar from the macro side, sanctions people from their side. We need to work together to understand how it works. And on the financial system sort of alternative systems in China, they're still very dependent on the global systems. And I strongly recommend, there is Emily Jeans testimony to Congress which really spells out some of this detail.

I think it's about a year old, it's moving every day, but I do think it's an important area to focus on.

>> Steven Davis: We're going to put a link to that testimony you just mentioned, Elina, we'll come back to you after the show. Find exact link and we'll put a link to that as well as your paper, by the way, on the Hoover Institution website for this show.

So if people wanna follow up and we'll put links to other relevant materials as well. So this really is, by the way, for anybody who's interested in the capacity of sanctions to really limit the economic performance and war fighting potential of current and possible future adversaries. This thing about the payment system really is critical.

And Oleg has already made the point very clearly, we don't really know whether this choke point will be so powerful in five or ten years, or even two years, as it is now. And we also don't know, I think, related to that, how successfully adversaries or potential adversaries like China can quickly devise alternative payment systems that would.

Even though it's a choke point now, might not be so much of a choke point in a future conflict. That's really a first order question at the intersection of economics and national security, as Elina has already hinted, or said directly, I should say.

>> Elina Ribakova: Absolutely.

>> Steven Davis: So, let's try to take stock here.

So here's my assessment, and just my attempt to give a high level summary of the effectiveness of these sanctions. And I wanna hear whether you agree with it and wanna fill it out or push back, is that, well, first, there was some hope, expectation that maybe we could trigger a financial crisis in 2022.

That was sufficiently serious that it would completely disrupt Russia's economy and greatly undermine its war fighting capabilities. That did not happen. It did not happen in part because of, as Elina described, the kind of, economic reform efforts that Russia had made after 2014 in a way that created this fortress Russia on the financial side.

The surplus in the trade account and Russia's fiscal account. So that's point one. Point two is economic trade sanctions, the kind of, economic side of trade sanctions have proved perhaps less impactful than anticipated because substitution responses have been rapid on many margins. And so, the extent to which the trade sanctions have compromised Russia's war fighting capabilities, at least in the medium term, in the near term, has been limited.

They may degrade its ability to create mischief over the next five or ten years, that's a separate issue. And then third, the most potent form of sanctions have been these payment sanctions, and we don't really know whether that potency will continue into the future. Especially with a different adversary, one like China, that has probably more capacity to create alternative payment systems.

That's kinda my overall read, have I got it basically right? Have I missed important things? Have I mischaracterized anything?

>> Oleg Itskhoki: Can I bring one emphasis here which I think is missing, fully on the same page regarding the financial crisis didn't happen. And there are a number of reasons, and a big question, given the circumstances, was it even possible to inflict a quick financial crisis?

But I think one thing to keep in mind is the scale of the expenditure that Russia puts on this war, right? So, the military expenditure combined are about 150 to 200 billion dollars a year. That's the GDP of Ukraine before the war. So Russia is trying to spend a full Ukrainian GDP to defeat the country, right, every year.

This is coincidentally, about the size of Russian oil revenues from experts, 150 to $200 billion. The sanctions chipped away 10 or 20% of those revenues. And that's not insignificant, but it's only 10 or 20%. And this is something to keep in the perspective. And in that sense, sanctions were effective at chipping away parts of these revenues.

Russian budget is actually in deficit at oil prices that are twice as high as they used to be before the war. So that's not insignificant. Russia has used up pretty much all of its national wealth fund to finance this war over the two and a half years. So this is really what keeps this machine going, right?

And it would be wrong to say that the sanctions didn't do much, it just that this machine was very, very well funded before the war. And that was not a coincidence, that was a result of a long preparation that perhaps was a response to 2014 sanctions, ironically, right?

And this is, I think, the key thing to keep in perspective. Of course, you wanna really throw in more, sending the wheels of this machine, and that's what sanctions are doing. That's what trade sanctions are doing, that's what payment system sanctions are doing. But have to keep the perspective of the magnitude and the scope of that machine.

>> Elina Ribakova: Russia is a weak power and it's a weakening power because of the war, because of the sanctions. It's very hard to say exactly how much here, how much there came from. But also just to carry on from some of the numbers Oleg was mentioning, unemployment in Russia is just about over 2%.

As you've studied many economists even around the world, it's not a natural rate of unemployment for Russia, right? We never thought that we're gonna get less than 7% in Russia. And that's why it's not surprising inflation is picking up, and at the same time, rates are more than 20%.

Russian central bank had to push up rates that far. We have, for the males of a certain age, unqualified, basically, males that can go to the war die, will produce domestically Kalashnikovs. We see some wage increases in nominal terms more than 30%. So it's almost like a weird U curve where the highly skilled, highly transferable, as you mentioned, IT and sort of, specialized scientist people have very high salaries.

And then this physical bodies of males of a certain age, with little qualification. So Russian economy is being squeezed. And in 2022, we had a lot of emerging markets, commodity exporters having spectacular growth. Russia had a small contraction, smaller than, of course, many hoped for. So yes, the glass is half full, Russian economy is struggling.

Russia has fully, sort of, almost fully have shifted expenditure to the war economy. They're trying their best, but they are forced to invest in North Korea or actually ship people from North Korea to be able to expand this supply. They've hit the supply curve limitations, and that's what we're seeing demonstrated in inflation and nominal wage growth in the rates.

>> Steven Davis: Okay, so that's all very interesting. I mean, I've been struck in this conflict, but even thinking back to the Soviet era, the capacity of the Soviet Union and now Russia to marshal economic resources for military purposes is pretty extraordinary. That's not a new thing in Russian economic history.

And there are some autocratic regimes, Russia, Soviet Union being one of them, that have shown repeatedly their capacity to, even with a weak economy, as Elina says. I mean, the Soviet economy was a weak economy compared to that of the United States and Western Europe. Nonetheless, it was one of the preeminent global superpowers of its day, and like the United States, had the capacity to obliterate all of humanity.

So even weak economic powers can cause an extraordinary-

>> Oleg Itskhoki: If you allow, can I add one emphasis here, which I think is extremely important in what you're saying. It's an authoritarian regime, and authoritarian regimes can do a lot of things that democracies cannot. In particular, you can divest or divert 10 or 15% of GDP from civil economy to a military economy in a matter of a year or two.

This is a dramatic impact on the economy, but because they There is no democratic process. The people have no way to express their opinions about it. And so this is really important to emphasize when you're dealing with authoritarian regimes. They can do a lot more than democracies can.

And this is exactly why it's so essential for democracies to form coalitions. Coalitions for economic reasons, but obviously, even more importantly, coalitions for military reasons. Democracies are completely weak against autocracies when you need to mobilize resources of this magnitude. And only building coalitions is something that allows democracies to withstand in this respect.

>> Steven Davis: Yeah, I agree with that. But I'd also say that part of the secret to national security and international security for democratic rule of law oriented regimes is the success of their economies. So they are much more successful economically, by and large. And that's true for the United States versus China as well.

We're incomparably more successful in terms of generating living standards improve and GDP per capita and so on. So that we're able to field effective militaries at budget levels that are a fraction of a much smaller share of GDP than what you see in economies like Russia and China and so on.

So the reason I emphasize that is just to keep the eye on the ball. Our economic success is vital to our national security.

>> Elina Ribakova: Absolutely, I meet a lot of colleagues. You do sanctions? How funny, sanctions don't work. Look at North Korea. I'm like, yeah, look at North Korea compared to South Korea.

So yes, the democratic ability to produce sort of more creative, more productive allocation of capital and resources overall does make a change. Look at Soviet Union.

>> Steven Davis: Right, all right, that's a positive note. It's a positive note and an important one, so let's end there. This was a great discussion.

I learned a lot, and I also learned a lot from your article, which I highly recommend to anybody who's interested in the intersection of economics and national security matters. Economic statecraft, I guess, is the term of art these days. So take a look. Thanks so much and stay well, both of you, and good luck in all your endeavors.

>> Oleg Itskhoki: Thanks a lot, Steve.

>> Elina Ribakova: Thank you so much, Steve.

>> Steven Davis: Okay, bye bye.