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The United States and its European allies struck back against Russia for its invasion of Ukraine this week by imposing a round of sweeping economic sanctions, punishing Russia’s largest banks, major state owned companies, and wealthy oligarchs, while taking steps to cut off its military and technology exports and its government’s ability to sell debt abroad. The moves already appear to be rattling Russia’s markets—stocks there are down around 20 percent since the invasion began, while the ruble has plunged.
While it is an impressive effort overall, the sanctions also have a glaring weakness: They largely spare Russia’s all-important energy sector, the backbone of its entire economy, and its agricultural center (the country is a major wheat exporter).
The NATO allies have chosen to leave these sectors alone in order to minimize the impact on Western consumers. This need—driven especially by German consumers, but also substantially by the Biden Administration’s fear of raising gas prices and fueling inflation in the U.S.—forced the U.S. Treasury Department to blow a hole in what would otherwise have been an effective form of financial retaliation.
The One Big Rule for Creating Good Sanctions
Before we examine yesterday’s sanctions specifically, we should first think about how sanctions work generally.
Normally, voluntary trade is good for both sides of a transaction because they each receive something that’s more valuable to them than what they gave away. This is known as consumer surplus, if you’re buying something you like at a favorable price, or producer surplus, if you’re selling something for a profit.
If you impose sanctions, you are sacrificing some of your own surplus to eliminate your target’s surplus. It’s not necessarily a great deal, but it can be less costly than a military intervention.
Whether sanctions are effective or not depends a great deal on who gets hurt more. One factor is how much room you have to take a hit. The United States and its European allies are substantially wealthier than Russia: even if you account for Russia’s low domestic price levels, its GDP per capita is less than half that of the United States.
Another factor is who takes the larger hit. There’s no guarantee that producers and consumers split the surplus evenly on any given trade. For example, if you have a splitting headache and you buy some acetaminophen from the only pharmacy that’s open near you, you probably needed that trade much more than the pharmacy did. But at other times, you might have plenty of options as a consumer, and find that sellers need you much more than you need any one of them.
The art of creating good sanctions, then, is to figure out restrictions that are much more painful to your target than they are to you. This is in fact the White House’s stated agenda: For example, Secretary of State Antony Blinken told CBS News’s Norah O’Donnell yesterday in an interview: “what we’re doing across the board is making sure we inflict maximum pain on Russia … while minimizing any of the pain to us.”
Why Sanctions Could Be Powerful—In Theory
Now, at least in theory, the U.S. has a great weapon for sanctions. The key is in the U.S. financial system, which has an extraordinary amount of power—at least, when it acts in unison at the direction of the government—because of the dollar’s status as a default currency for settling many kinds of transactions.
Generally, a lot of basic banking services are competitive and low-cost. “Pennies on the dollar” is a generous description of how much banks make on many ordinary transactions. But if you suddenly found yourself without access to banking services, you would be in a lot of trouble very quickly. You need banking more than banking needs you. So banking is a perfect place for inflicting the sort of asymmetric pain that makes a good sanction.
How does this work in the context of sanctioning Russia? One promising tool is limiting their access to something called correspondent banking. Correspondent banking is extremely important for access to global markets.
Here’s what correspondent banking does. When, for example, a Vietnamese firm buys something from a Colombian firm, they need to pay for it. But of course, it’s not like they dig into their wallets, fish out some cash, and put it on a ship across the Pacific. Instead, they agree to subtract the payment from their bank account and add it to the Colombian firm’s bank account.
But there’s a problem with this. They don’t have accounts at the same bank, and the two banks don’t really know each other—it would be ridiculously inefficient for every single bank in the world to have a protocol for interacting directly with every single other bank.
So instead what the two banks are likely to do is interact with each other through a correspondent bank: a bank where both the Colombian bank and the Vietnamese bank have accounts, and which can act as an intermediary.
Because the dollar is the world’s most important currency, the bulk of the correspondent banking sector is located in the U.S. and works in dollars.
This is the service that the U.S. Treasury Office for Foreign Assets Control (OFAC) will deny to Sberbank, Russia’s largest financial institution. On Thursday, Treasury released a document describing the actions it has taken so far on sanctions. It reads:
Within 30 days, OFAC is requiring all U.S. financial institutions to close any Sberbank correspondent or payable-through accounts and to reject any future transactions involving Sberbank or its foreign financial institution subsidiaries. Payments that Sberbank attempts to process in U.S. dollars for its clients — with examples ranging from to technology to transportation — will be disrupted and rejected once the payment hits a U.S. financial institution.
Correspondent banking is ultimately a pretty mundane service, to the point that I almost want to apologize for spending all this time describing it. It’s possible you’d never heard of correspondent banking until now. Few Americans derive their livelihoods from correspondent banking, and even fewer from the small subset of correspondent banking services that go to Russia.
And yet, even if our correspondent banking industry isn’t a huge source of wealth to us, it’s obviously extraordinarily important to businesses that engage in any sort of international trade. It’s essentially a hidden key to international markets. So while it would not be painful for us to exclude Russia from our correspondent banking services, it would be deeply painful to them to be excluded.
So in theory, this is a great form of sanction. But there’s a catch.
The Big Loophole
The problem with damaging Russia’s access to the international banking system is that Russia uses it in large part to export energy. And the White House has been very clear: it does not want to harm global energy markets.
“We’ve intentionally scoped our sanctions to deliver severe impact on the Russian economy while minimizing the cost to the U.S. as well as her allies and partners,” said Daleep Singh, a deputy National Security Advisor and deputy director of the National Economic Council in a press conference yesterday. “To be clear, our sanctions are not designed to cause any disruption to the current flow of energy from Russia to the world.”
As a result, Treasury was required to put a big loophole in what otherwise would have been a very successful financial dragnet. As the Treasury document describes it:
To ensure that these sanctions and prohibitions have an impact on the intended targets and to minimize unintended consequences on third parties, OFAC has also issued several general licenses in connection with these actions. In particular, payments for energy are from production to consumption. The sanctions and license package has been constructed to account for the challenges high energy prices pose to average citizens and doesn’t prevent banks from processing payments for them.
Specifically, OFAC issued eight general licenses authorizing certain transactions related to:
- international organizations and entities;
- agricultural and medical commodities and the COVID-19 pandemic;
- overflight and emergency landings;
- dealings in certain debt or equity;
- derivative contracts;
- the wind down of transactions involving certain blocked persons; and
- the rejection of transactions involving certain blocked persons.
Between agriculture and energy, a huge portion of Russia’s trade has licenses that can help get around the financial blockade. And the scope of these licenses is large. For example, here is General License 8, which handles energy:
For the purposes of this general license, the term “related to energy” means the extraction, production, refinement, liquefaction, gasification, regasification, conversion, enrichment, fabrication, transport, or purchase of petroleum, including crude oil, lease condensates, unfinished oils, natural gas liquids, petroleum products, natural gas, or other products capable of producing energy, such as coal, wood, or agricultural products used to manufacture biofuels, or uranium in any form, as well as the development, production, generation, transmission, or exchange of power, through any means, including nuclear, thermal, and renewable energy sources.
That’s a lot of exemptions, especially as far as Russia’s energy-heavy economy is concerned. And I know from work in tax policy that when you have an onerous system in one sector and exemptions in another, cash finds its way into the favored categories through dubious re-categorizations.
Per the Treasury FAQ, Russian banks can transact with U.S. financial institutions provided that they are authorized under the general license (basically, if they say that the transaction pertains to energy) and the Americans ping-pong their funds indirectly through a non-sanctioned foreign bank. The FAQ even offers diagrams to explain how you can get money to and from Russia under these guidelines.
Ultimately, there’s a pretty obvious political tradeoff that was made here. The financial wizards at Treasury had a powerful idea for a sanctions regime, but scaled it back in order to protect Western consumers.
As Matt Zeitlin wrote for Grid News on Wednesday, there would always be a tension between the need to protect consumers and the need for a response to the Russian incursion. Biden is dealing with a troubling narrative around inflation, especially in gas prices, which makes him unfortunately more dependent on the health of the global oil market than he would like. Furthermore, Germany’s dependence on Russian oil is even more direct; as foreign policy analysts have long predicted, they have pushed heavily for energy carveouts.
Western citizens have effectively placed impossible constraints on their governments. They want to respond to the invasion, but they don’t want military intervention, and they aren’t willing to take on the economic pain of a more effective sanctions regime. Working within those impossible constraints, I think the Treasury is doing about as well as can be expected.
In the longer run, Europe and the U.S. alike need to be more aggressive at creating their own energy supply, so they have more flexibility when dealing with Russia or other energy-rich but ill-behaved states.