The perils of financial warfare

Nicholas Mulder
March 22, 2014

The first exchanges of sanctions between modern industrial states occurred during Anglo-German rivalry in the early twentieth century. Above is a German plan to blockade Britain from 1915.

Over the past two weeks, American and  European efforts to find an effective response to the Russian annexation  of the Crimea have led to the adoption of several sanctions. A lively  debate has kicked off in the media and among Western politicians,  policymakers and commentators about the question of sanctions and their  effectiveness. The sense that something had to be done in response to  Russian actions is widespread, but whether sanctions are the right way  of bringing political pressure to bear on Putin’s government is far from  clear.

Sanctions have emerged over the course of  the last century as one of the preferred methods for bringing unruly  governments to the negotiating table. In a broad sense, they include all  forms of consciously and directly applied pressure that curtail a  country’s ability to conduct its habitual economic activity. But  sanctions are more than just pressure tools in the way in which  lobbying, aid and international law are; in their concrete effects, they  can become economic weapons. Joseph Nye, the oft-cited doyen of modern  international relations theory, therefore considers them a form of ‘hard  power’.

Sanctions come in many different varieties.  On the spectrum of forcefulness, they range from subtle and almost  harmless inducements to all-out economic warfare. Modern proponents of  sanctions (including Nye)  argue that if they are correctly employed, so-called ‘smart sanctions’  can force the hand of uncooperative governments with minimal collateral  damage.

Highly developed economies, especially those with democratic  electorates, have always found sanctions an appealing course of action.  For one thing, the costs of deploying them are almost always lower than  those of waging war directly, especially when the country being targeted  is a small and relatively insignificant trading partner. For another,  advanced economies with strong and far-reaching trade and financial  networks are more conducive to being ‘weaponised’ than simpler economies  that have less of a stake in global trade and finance.

Historically, the idea of sanctions as a distinct foreign policy tool  emerged during the first era of financial and economic globalisation,  roughly between 1880 and 1914. If we want to understand what sanctions  can (and cannot) do today, it is worth reviewing their development over  the last century.

A brief history of financial sabotage

Initially, sanctions were viewed as  strategic instruments used by individual Great Powers. In the years  leading up to World War I, policymakers at the British Admiralty  realised that their country’s dominant position in global industry,  maritime commerce and finance gave it an unrivalled ability to ward off  threats to its imperial supremacy. They soon set out to develop a  strategy aimed at containing Britain’s main European opponent, Germany.

As military historian Nicholas Lambert has recounted in gripping detail in his study Planning Armageddon : British Economic Warfare and the First World War  (Harvard University Press, 2012), British naval planners aimed to  exploit the country’s leading position at the apex of the global  capital, shipping, and insurance markets to bring the German empire to  its knees and cripple its war effort. The Admiralty proposed that the  British government could extend administrative control over the banks  and markets of the City of London in order to make this happen. They  imagined that if applied correctly, German overseas trade, banking and  industry would all but collapse. As an Admiralty policy paper from 1908  argued:

It seems, then, that we must do  all in our power to check German industrial output, or if possible stop  it at its source (i.e., prevent the import of raw material). The effect  of this proceeding would be to “discredit” her and deprive her of the  power of obtaining outside monetary assistance.[1]

Although British traders and financiers  would suffer some setback in their turnover, the damage inflicted on the  German economy would be disproportional, and the conflict could be won  quickly and at low human and material cost.

In the event, this complex strategy of  economic warfare faltered when World War I broke out. A panic in  financial markets prevented the government from taking effective action  to weaken Germany in the first few weeks of the conflict. When the  Admiralty finally thought  its plans would be realised, opposition from powerful economic  interests and diplomatic partners made Prime Minister Herbert Asquith’s  cabinet reconsider its approach. City bankers, the British Board of  Trade, the Foreign Office and even the United States convinced the  government to ditch the Admiralty’s strategy in the interest of  stabilising global financial and commodities markets.

Instead, during the first year of World War  I the Allies imposed a more passive and conventional naval blockade.  This was a slow-acting weapon. The blockade progressively reduced the  flow of imports into Germany, but it allowed the war to drag on for four  more years and starved the population of Central Europe so badly that  the Allies were forced to organise a major humanitarian relief effort in  1918 and 1919. In the long run, moreover, the trauma of the blockade  contributed to the social destabilisation of Central Europe during the  interwar period and the political tensions that led to World War II. The  first organised deployment of economic sanctions against a major  country in the world economy, then, was a failure. The embargo did not  achieve its goal within the intended timeframe; when it finally did, the  costs were much higher than anticipated; and the whole strategy had  significant unintended consequences in the short term and long term.

Even so, British policymakers continued to think of ways to pursue  economic and financial destabilisation by other means. A few weeks ago I  came across some interesting documents in the John Maynard Keynes archival collection held here at King’s College which illustrated this very poignantly.

In August 1917, the British Foreign Office sent a series of  diplomatic cables to the British ambassador in Rio de Janeiro, Sir  Arthur Peel, in which it outlined an audacious plan for financial  warfare. It was suggested that German banks operating overseas in  neutral Latin American countries could be targeted in order to weaken  Germany’s ability to finance the war in Europe. The Foreign Office asked  Peel if he could spread rumours about the creditworthiness of German  banks in local newspapers so as to trigger a bank run. If American banks  in the region agreed to cooperate in the plot by refusing to refinance  the distressed banks when they asked for help, then this calculated  ‘introduction of a want of confidence in the solvency of German banks’  could inflict severe financial losses on their parent companies and  weaken the German war effort.

Ambassador Peel’s response was that such financial destabilisation  was easier said than done. The reality on the ground was much more  complicated than it appeared from Whitehall. Brazilian and Argentinian  businesses in which British and American investors held significant  interests also held accounts and received loans from German banks.  Moreover, the German banks could always overcome any Anglo-American  refusal to refinance them by recourse to Dutch and Spanish banks in the  region, which belonged to neutral countries.

Peel therefore expected that the Brazilian financial destabilisation  plan would prove either ineffective, because it could be evaded, or  counterproductive, because it was likely to harm British assets abroad.  Keynes, who was then the chief foreign debt negotiator at the Treasury,  was belatedly notified of the Foreign Office’s bold plan. He stopped the  attempted sabotage from being executed by denouncing it to the  Chancellor of the Exchequer in a furiously scribbled note:

I submit that this kind of thing is the foolishest thing in the  world, very unlikely to be successful and if discovered lending colour  to a charge of our complicity in a sort of iniquity which we publicly  allege to be the peculiar prerogative of the enemy.[2]

The message was clear. In a globally  connected financial system which connected banks, investors and firms,  purposely inducing a banking panic was an incredibly dangerous thing to  do—even while a world war was raging. Unintended financial panics,  manias and crashes are already bad enough in themselves, and pretty much  inevitable in the long run, as any experienced investor knows. But deliberately  triggering such crises was not just politically inexpedient, but also  highly irresponsible. The consequences of fostering financial  instability in third countries would be impossible to foresee, let alone  control. The same vulnerability to shock and contagion that Peel and  Keynes identified in 1917 still characterises today’s global financial  system, with its transnational exposure, immediate transactions and  highly mobile assets. A more subtle and focused approach to economic  coercion was needed.

Sanctions and the global economic balance of power

The tendency for particular countries to  dominate global trade and finance sustained the appeal of sanctions.  Throughout the twentieth century, sanctions represented an attractive  weapon in the arsenal of the reigning global economic power (see this timeline of sanctions  regimes from 1914 to 2006). Before the 1920s, Britain pioneered their  use in various ways. The instability of international politics between  the world wars meant that there was insufficient international consensus  to make sanctions work properly. During this period the League of  Nations attempted to enforce a liberal international legal and economic  order with the carrot of financial assistance and the stick of economic  sanctions.

However, internal disagreement and the  slump of the Great Depression caused its sanctions regimes (such as  those imposed on Mussolini’s Italy after its invasion of Abyssinia in  1935) to crumble. What the League’s experience did achieve, however, was  a reframing of sanctions as lawful economic penalties imposed by an  international community against defiantly aggressive states, a worldview  later expounded by the United Nations.

After World War II, the United States  assumed global economic leadership, and with it a prime position in  administering sanctions and trade embargoes. American financial and  monetary preeminence in the world economy has certainly provided a much  needed degree of stability for much of the post-WWII era. Washington’s  participation in international sanctions regimes, such as that directed  against apartheid South Africa in the 1980s, was often instrumental to  their success. But over the last two decades, the rise of the BRIC  economies (Brazil, Russia, India and China) and other emerging markets  and the slowdown of growth in industrialised countries has reduced America’s leading position in the use of sanctions.

After a new round of financial  globalisation took off in the 1990s, many countries started to employ  sanctions to supplement or replace political or military action. Most  sanctions have stayed clear of meddling in the financial markets of the  countries they targeted. Instead they have usually focused on affairs  closer to home, freezing the assets of foreign nationals held within  their own borders, revoking legal and trading privileges, and imposing  punitive restrictions on the movement of people, goods and capital. Such  moves involve relatively little effort and can easily be reversed when  the situation improves and a political or diplomatic arrangement with  the opposing country is reached.

At the same time, it has become more  difficult to distinguish sanctions from other forms of economic control.  Starting in the late 1970s, the IMF and World Bank started imposing  stricter financial discipline on irresponsible borrowers and spendthrift  governments (a practice begun by the League of Nations). States could  now be punished for acts of economic misbehavior as well as political  aggression.

Sanctions are similar to taxes in that the  burden of bearing them can easily be devolved onto non-targeted groups  if they are not properly designed. The most famous case of such a design  failure was the sanctions regime that was imposed through a series of  UN Security Council resolutions against Saddam Hussein’s Iraq in the  1990s. The costs of these sanctions were ultimately borne largely by the  Iraqi population, which was dramatically impoverished, suffered from  severe malnutrition and saw its living standards fall precipitously.  UNICEF later estimated that the Iraqi sanctions caused between 100,000  and 227,000 excess deaths between 1991 and 1998. They did little to remove Saddam from power.

What role can sanctions play in the global economy of 2014?

In an age of economic liberalism, political elites are drawn to the  idea that persuasion can be produced by altering the ease of doing  business rather than creating shared interests, offering political  concessions or waving a gun. The reluctance of Western countries to  become embroiled in additional military adventures overseas contributes  to their preference to employ sanctions. The current support for  sanctions against Russia is based to some degree on the perceived recent  success of American- and UN-imposed sanctions against Iran. Economic  analysts and military strategists have credited ‘smart sanctions’ (which  reduced the number of buyers of Iranian oil without blocking it from  the global petroleum market) aimed at state-held oil companies  and the Iranian central bank with the success of pressuring Tehran into  seeking a diplomatic agreement with the West and suspending the  development of its nuclear programme.

But Russia is not Iran. What makes the current sanctions against  Moscow unprecedented is that are imposed against the world’s eighth  largest economy (controlling 2.7% of global production) and its largest  oil producer (controlling over 13% of global crude oil production). It  will be immeasurably more difficult to isolate Russia’s economy than it  has been to progressively decouple Iran, Syria and North Korea. If it  were to be attempted, such a process would take years, which would rule  it out as an appropriately measured response to the current Ukrainian  crisis.

And the long-run fallout of such a strategy would in likelihood be  far graver. Russian membership of the G8 and the G20 mean that  substantial sanctions will destroy any prospect of achieving global  macroeconomic coordination in the near future. At any rate, the  sanctions seem inherently limited in their impact by the lack of an  international consensus to uphold them. Asian countries are not following the lead of Europe and the US: China has been conspicuously silent about Russian actions, and India is still on the fence but seems unlikely to join the West.

Comprehensive sanctions against Russia,  even if they are not reciprocated, have the potential to backfire  against the American and European economies. The EU, which imports a  large part of its natural gas from Russia, is much more strongly aware  of this than the Obama Administration. As the Brussels-based think tank Bruegel  put it, ‘sanctions are not about how much damage can be inflicted on  the sanctioned, but about how much pain the sanctioner can tolerate’.  But even the United States has reason to want to proceed extremely  cautiously. One need only recall that the last time the Russian  government temporarily stopped paying back its debt, in August 1998, the  shock waves produced by this event caused the bankruptcy of the most sophisticated hedge fund in the world at the time, Long-Term Capital Management (LTCM).

Today major Western corporations including the American manufacturers Boeing and General Electric, German electronics giant Siemens, the Texan oil and gas company ExxonMobil (which is involved in a joint venture  to develop an oil field in the Arctic Ocean together with the Russian  state oil company Rosneft) and the major French bank Société Générale  (which owns Rosbank, Russia’s second-largest bank) have significant  investments in Russia and are exposed to the state of its economy. And  in finance, as in geopolitics, the Russian government retains the  ability make significant and unexpected moves. Two weeks ago, about $105  billion in US Treasury bills (American government bonds) were moved  in the space of a few days—the largest transfer out of the Fed’s T-bill  accounts in years—as Moscow has apparently moved its holdings of  American government debt offshore in order to prevent them from being  frozen.

To be sure, the sanctions currently being  considered by the Obama Administration and European governments still  fall well short of fully-fledged economic warfare. Invocations of a ‘new  Cold War’ are overdrawn, as the West and Russia are still far away from  military confrontation. But we should realise that the rapid pace of  financial globalisation in recent decades has moved us much closer to  the boundary between manageable and unmanageable economic restrictions.   Those who think that sanctions against Putin and his ruling clique are a  good alternative to more direct confrontation with Russia (an option  that few Western leaders find attractive, and rightly so) are prone to  overestimate the space available to escalate economic pressure if the  Kremlin shows no sign of budging. It is very difficult to think of  economic interventions that would seriously impair Russia’s ability to  project political and economic might broad but would not carry a serious  risk of spiralling out of control.

The resurgence of global financial  capitalism since the 1990s has lent support to the idea that economic  pressure can substitute for military intervention in the arena of  international politics. But the exceptional interdependence of modern  economic networks has simultaneously brought us much closer to the  threshold beyond which full-fledged collapse ensues. Paradoxically, the  intertwined nature of today’s global economy makes sanctions at once  intuitively more attractive, practically less effective, and potentially  more dangerous than in earlier stages of the world’s economic  development.

Sharing responsibility versus sharing prosperity

None of this is to suggest, of course, that  war is the preferable foreign policy option. War remains an even more  blunt, costly and reprehensible way of achieving one’s objectives than  sanctions. But we should not delude ourselves into thinking that we can  solve the messy problems of politics and escape the uncomfortable  compromises of diplomacy by deploying sanctions that are clean, quick,  and restricted. Sanctions are usually none of the three; they are  tortuous to implement, can take a long time to take effect and almost  always produce unintended spillover effects.

Those who design sanctions must take into  account the nature of the economic and political system into which they  are released. And there is also a deeper question about how sanctions  are to function in the global political order. Troublingly, the question  of sanctions brings to the fore a conflict between the logic of  international law—enforcing the rules as they stand—and the logic of  global macroeconomic coordination—preserving the stability of the world  economy. It is a clash between the agendas of the United Nations  Security Council (sharing responsibility) and the G20 (sharing  prosperity).

At a time when mass surveillance, the use of drones and the threat of  cyber-attacks dominate the news, it may seem as if ‘hard power’ has  been replaced by ‘smart power’. Indeed, an increasing number of  international relations theorists and foreign policy pundits seem to  believe this. In the realm of technology, we have developed more  sophisticated instruments, but in economic matters things are quite  different. The uncertainty about the distribution of risk that fuelled  the global financial crisis in 2008—who is exposed to who?—makes  deliberate financial sanctions a potentially extremely destabilising  tool.

The notion that we can execute the economic equivalent of a military  ‘surgical strike’ is an appealing one. But it glosses over the  intricately interrelated nature of trade, capital flows, money and  commodity prices in the global economy.  What we initially conceived of  as a thumbscrew may turn out to be a sledgehammer.


[1]  Admiralty, “The Economic Effect Of War On German Trade”, 12 December  1908, Appendix 5 (Cid E-4), Cab.16/5, Paragraphs 22, 24, 31, Cited In  Lambert, Planning Armageddon, P. 123.

[2] Jmk Collection, King’s College Archive, King’s College, Cambridge, Folder T/21/1.

All by
Nicholas Mulder