The Ukraine Conflict, Economic-Military Power Balances, and Economic Sanctions: lessons from the past for future EU policies

Ucrania, Rusia y la Unión Europea. Elcano

Theme: How generously should the EU support the reform and recovery of the Ukraine economy? Should the EU de-couple its policies concerning anti-Russia economic sanctions from those of the US? Should the EU countries discourage NATO from providing military assistance to the armed forces of Ukraine?

Summary: This analysis begins by identifying lessons for the understanding of the conflict in Ukraine and contemporary economic sanctions from the histories of the dynamics of economic and military power balances in Europe leading up to 2013 and of Western economic warfare directed against the USSR. It evaluates a number of empirical issues, such as the impacts of sanctions on the economy of Russia, and then provides brief answers to three key questions related to EU policymaking in 2015: (1) How generously should the EU support the reform and recovery of the Ukraine economy?; (2) Should the EU de-couple its policies concerning anti-Russia economic sanctions from those of the US?; and (3) Should the EU countries discourage NATO from providing military assistance to the armed forces of Ukraine?


The Rise and Fall of the USSR as a Great Power, Western Economic Warfare, and Conventional Deterrence in Europe During the Cold War
Although Russia declined as a European economic and military power following the Bolshevik Revolution and Civil War, its revolutionary program was perceived as a threat by leading capitalist nations. These concerns were intensified when Stalin’s policies generated rapid economic growth and substantial increases in military power in the 1930s, which provided the foundation for the successes of the USSR in World War II.

From 1917 until 1991 foreign powers waged economic warfare against and imposed sanctions on the USSR in order to constrain the development of its economic and military power. However, there often were divisions between countries over anti-Soviet policies. Germany provided important covert assistance to Soviet Russia throughout the 1920s. The rapid Soviet industrialization in the 1930s benefited from large-scale exports to Stalin’s USSR of machinery and equipment by Western firms, notably American ones. Germany assisted the Soviet Union economically during 1939-41, whereas the US and Britain provided it with help over 1941-45. Due to forcible inclusion from 1940 of the Baltic and East European countries in the Soviet-led socialist system, the newly formed (1949) NATO alliance adopted containment policies that involved formalized economic warfare against the USSR under the supervision of CoCom. All important industrialized countries participated in these restrictions on trade and finance that remained in effect until the end of the Cold War.

The Soviet Union developed economic warfare counter-measures against the capitalist countries that involved embargoes, trade diversion, and technological espionage. By the 1960s the USSR had a well-organized and effective Spetsinformatsiya (special information) system that obtained restricted Western technologies on a large scale using covert means.

In the post-war period the Soviet economy grew rapidly. Despite Western technology controls, the Soviet Union was successful in developing nuclear weapons, ICBMs, strategic bombers, nuclear submarines, and sophisticated conventional weapons. The USSR became the dominant economic power in Eurasia and the second “superpower” in military terms.

Two cases of Cold War anti-Soviet economic sanctions have parallels with the current Ukraine situation. In response to the invasion of Afghanistan in 1979 by the USSR and the imposition of martial law in Poland in 1981, the US imposed draconian controls on the export to the communist bloc of energy-related technologies and asked its NATO partners to participate. However, West Europe decided to ignore the US sanctions and instead to cooperate with the USSR in building the 4,500 km natural gas pipeline from Urengoi to Uzhgorod (Ukraine) during 1982-84. The second case relates to the 1983 shooting down by a Soviet fighter of the Korean Airlines (007) civilian passenger plane that had strayed into Soviet airspace. The world community was appalled by this action and additional sanctions were imposed in response. These remained in place for less than two years because of the decision by Western powers in 1985 to work constructively with the new reformist Soviet leader Mikhail Gorbachev.

During the late Cold War period NATO substantially built up its conventional and strategic nuclear forces and achieved deterrence in Europe. This required substantial commitments of resources to defense: US 6 % of GDP, UK 5 %, France 4 %, Germany 3 %. The US and USSR engaged in numerous proxy conflicts in the Third World. The US had mixed success in supplying weapons to weak regimes threatened by revolutionary forces. Cases of defeat with the loss of all US weapons included Vietnam 1973, Ethiopia 1974, and Nicaragua and Iran in 1979.

Although there were military tensions in Europe during 1945-1989 there were no armed conflicts or European border changes. The US did not recognize the 1940 annexations of Estonia, Latvia and Lithuania, but it treated this as a side-issue in order to manage its relations with the USSR for the sake of global stability.

The communist regimes in Eastern Europe collapsed in 1989 and in the USSR in 1991 due to economic problems, excessively heavy defense burdens, and population dissatisfaction. Economic warfare and sanctions played only minor roles in altering economic and military power balances and in bringing about regime change.   

Absolute and Relative Declines in the Economic, Technological and Military Power of Russia and Ukraine in the 1990s
Russia and Ukraine emerged as independent states in 1991 with similar Soviet inheritances and close economic linkages. Economic transition in the 1990s proved difficult for both countries with GDP collapses of about 40%, high inflation, corrupt privatization processes, limited industrial restructuring, and little FDI. In contrast, OECD economies experienced healthy growth and technological progress accelerated. So the gap in economic power between Russia and the West widened. The East Europe and Baltic countries engaged successfully with necessary reforms and their economies recovered quickly.

In Russia and Ukraine the priority of the military-industrial complex was downgraded. Defense expenditures were drastically reduced, military capabilities deteriorated, and negligible progress was achieved in reforms of the armed forces or defense industry.
The effectiveness of NATO armies remained high and new military technologies were introduced (stealth design, smart bombs, drones). However, European countries obtained an economic “peace dividend” by reducing defense expenditures, military personnel and weapon systems. For example, the number of UK Main Battle (MB) tanks dropped from 1,330 in 1990 to 636 in 2000. Substantial withdrawals were made of the military forces deployed in Germany of the US, UK and France. In 1999 the membership of NATO was expanded to include Czech Republic, Hungary and Poland.

In the post-Cold War period there has been significant instability of the borders of countries in Europe with a total of 30 alterations. There were peaceful changes in 22 cases: reunification of Germany; fragmentation of the USSR into 15 successor states; division of Czechoslovakia; independence of Slovenia and FRY Macedonia; and Serbia and Montenegro splitting. Three states achieved independence following wars: Serbia-Montenegro, Bosnia-Herzogovina, and Croatia. In five other cases regions of a state achieved autonomy through armed conflict, usually involving a foreign power, and thereafter entered the category of “frozen conflict”: Transnistria (1992), South Ossetia (1992), Abkhazia (1993), Nagorno-Karabakh (1994), and Kosovo (1999).

Recovery in Russia, Stagnation in Ukraine, Expansion of the EU and NATO, and Power Balances in Europe in the 2000s
The main economies in the world (now including China) grew at healthy rates during 2000-2008. The Baltic and Central East European countries benefited from inflows of FDI and completed their accessions to the EU in 2004 and 2007. However, the Global Financial Crisis (GFC) provided a severe negative shock to European economies. Despite resulting economic problems and austerity policies, the EU continued to expand, granting membership to Croatia in 2012, and made efforts to involve Former Soviet Union (FSU) states through the European Neighbourhood Policy (ENP).

In Russia Vladimir Putin was elected President in 2000 and has remained the dominant leader since then. Market-oriented reforms were only partially successful in the 2000s, but the Russian economy benefited substantially from the rise in the world market price of oil to a peak of $145 in 2008. Russia deepened its integration into the global economy and prudently built up a stabilization fund using taxes on energy exports. In 2012 Russia joined the WTO and published plans calling for closer economic links with the EU.

From 2000 Russia raised the priority of the defense sector, adopted an ambitious weapons procurement program, and intensified military reforms. According to SIPRI, real ($2011) defense spending increased from $31 billion in 2000 to $85 billion in 2013. The defense share of GDP rose from 3.6 % of GDP to 4.2 % (World Bank). The size of the armed forces was reduced from 1,004,100 to 845,000 and the number of MB tanks from 12,920 to 2,550 as part of modernization. The Russian military engaged in counter-insurgency operations in the Caucasus and fought a successful war against Georgia over South Ossetia in 2008. 

Ukraine has had a democratic but unstable political system. The peaceful Orange revolution in 2005 held out the promise of democratic reforms and reduction in pervasive corruption, but the pro-West government was ineffectual and was replaced following the 2010 election by the more pro-Russian President Yanukovich. The Ukraine economy made limited progress with economic reforms and performed poorly with respect to growth, inflation, unemployment, and foreign debt (78 % of GDP in 2013). Ukraine remained economically dependent on Russia.

Due to economic difficulties and the low priority accorded to defense in Ukraine, military expenditure fell as a share of GDP from 3.6 % in 2000 to 2.9 % in 2013, although it increased in real ($2011) terms from $2 billion to $5 billion. The number of troops was reduced from 303,800 to 130,000 and MB tanks from 3,895 to 1,110. The Ukraine armed forces had low pay and poor conditions for officers, obsolete weapons, and inadequate training.

During 2000-2013 NATO continued to withdraw conventional forces from forward-operating bases. By 2013 the US had only 53 MB tanks and 48 helicopters in Europe (CFE zone). National armies were reduced. Germany cut the size of its armed forces from 321,000 to 186,450 and the number of MB tanks from 2,815 to 322. NATO defense spending rose after 9/11 2001, but most the increment was devoted to War on Terror operations. Defense expenditure was reduced significantly in most European countries after the GFC and by 2013 their average defense share of GDP was 1.6 %.

Despite the military and expenditure cutbacks, NATO expanded its membership by including the Baltic and East Europe countries in 2004 (Bulgaria, Estonia, Latvia, Lithuania, Romania, Slovakia, Slovenia) and 2009 (Croatia) and developed closer relations with states in the FSU (Georgia, Ukraine, Moldova). NATO Europe per capita defense expenditure in real terms ($2005) dropped from $715 in 1990 to $515 in 2000 to $401 in 2013.

Over this period NATO countries also significantly scaled back intelligence (CIA/MI6 and defense specialists) efforts focussed on Russia, and the best analysts were redeployed to counter-terror activities. In 2011-12 the US announced that it would be making a major shift in its strategic focus away from peaceful Europe to the Asia-Pacific region to deal with new threats.

The US continued its poor record of supplying weapons to weak armed forces that were then defeated and lost their supplies to US opponents: Afghanistan army 2001 ongoing (to the Taleban); Georgia army 2008 (to Russia); Iraq army 2014 (to ISIS); Syria democratic forces 2015 (US anti-tank weapons to al-Nusra Front); Yemen army 2015 (to al-Houthi and al-Qaeda rebels).

Conflict in Ukraine, Anti-Russia Economic Sanctions, Exogenous Economic Shocks, and Russian Counter-Measures
The progression of the Ukraine conflict from the start of the Maidan protests in autumn 2013 to the revolutionary overthrow of President Yanukovich in February 2014 to the war in the eastern regions to the Minsk II accords of February 2015 is well known and cannot be reviewed in this article. In response to the annexation of Crimea, the armed conflict, and the shooting down of Malaysia Airlines 17, economic sanctions were imposed on Russia by the EU, US, Canada, Japan, and several other countries. The measures included restrictions on individuals (bans on travel, freezing of assets), trade (no transactions related to Crimea or exports to Russia of weapons and military equipment, dual-use technologies, and energy exploration technologies), and finance (exclusion of specified banks and businesses from credit markets, reduction in the period of loans).
Two features of anti-Russia sanctions have undermined their effectiveness, especially with respect to trade restrictions. The first is the non-participation of important industrial countries: Brazil, China, India, Indonesia, South Korea and Turkey. In the Cold War era all major economic powers observed CoCom restrictions. The second is that NATO countries have outsourced much of their electronic and high-technology production to the lower wage non-participating countries. This will facilitate Russian trade diversion and covert technology acquisition.

A beneficial development for anti-Russia sanctions was the coincidental exogenous shock of the drop in the world market price of oil (Brent Crude) from $115 per barrel in June 2015 to $50 in January 2015. This lowered Russia’s dollar earnings from energy exports, which weakened the financial positions of its banks, businesses and government. It constrained Russia’s ability to replenish the stabilization funds based on energy taxes that are being used to offset the adverse impacts of sanctions.

As in the Soviet period, the Russian government has adopted multi-dimensional and asymmetric counter-measures in response to sanctions. With respect to Ukraine, it imposed restrictions on exports to Russia, cut energy subsidies, and refused to sell gas without pre-payment. Another measure was the ban of imports of food from the sanctions countries and subsequent efforts to find alternative suppliers in non-participating nations. However, Russia also has provided positive incentives to EU member states that have been critical of anti-Russia sanctions. A new sanction introduced in March 2015 is the ban on Western IT firms based in Russia from bidding for state contracts (about 70 % their revenue) if they are observing Western restrictions on doing business in Crimea. Several policies have been adopted to promote import-substitution and have been supported by major state budget allocations.

Russia has decided to move back toward self-sufficiency in defense and it has revived the priority protection system in economy. It is likely that Russia has re-energized its Spetsinformatsiya system and that relevant specialists and institutions are engaged in trade diversion through non-participating countries and in the covert acquisition of banned technologies and finance. Experience in recent years has revealed the difficulties in regulating the complicated global financial system, so it will be challenging for the small and hastily organized EU/US compliance teams to ensure that sanctions are observed. In connection with security-related developments, President Putin became Head of the Military-Industrial Commission in September 2014.

Impacts of Sanctions on Russia, Ukraine and EU in 2014-2015
The performances of the economies of Russia and Ukraine deteriorated 2014 and are projected to be poor in 2015. Some studies claim that the worsening economic situation in Russia is proof that the sanctions have been achieving their objectives.

However, it is almost impossible to measure the specific impacts of sanctions on the Russian economy because of the coincidental disruption caused by the drop in oil prices and lack of information of the effectiveness of Russian counter-measures. The World Bank (April 2015) has made a careful professional analysis of this topic, but almost every tentative conclusion has several qualifications following it.

With respect to the technical implementation of sanctions, it is clear that banned individuals have had their assets in the West frozen and can no longer obtain visas for travel to many countries. Both foreign and Russian companies have been inhibited from investing and trading in Crimea. Russian banks and businesses, whether specifically sanctioned or not, have experienced difficulties in obtaining new loans in Western capital markets and rolling over existing ones. In the case of restrictions on the trade in technology, decrees have been issued by the EU and US. Firms based in the US or the UK no longer sell military-equipment or energy exploration technology directly to Russian firms. However, it probably is the case that some now banned critical technologies were stock-piled in advance of the crisis by Russia and other technologies are flowing though indirect and complicated routes to end users in Russia. 

In assessing the macroeconomic impacts of sanctions on Russia it is helpful to consider the counter-factual of Saudi Arabia not driving down the oil price. If Russia had continued to receive payment of $100 per barrel from June 2014 to the present, then it is likely that many of the negative phenomena in the Russian economy (large capital outflows, depreciation of the exchange rate, unstable equity market, reductions in imports, higher inflation, negative GDP growth) would not have developed, even with geopolitical tensions and sanctions. Furthermore, the Russian government would have been able to augment its stabilization funds and to provide more assistance to Russian banks and firms that became vulnerable in foreign capital markets.

However, in reality the oil price did drop so sanctions must be assessed in conjunction with the decline in Russia’s hard-currency energy earnings. Anti-Russia sanctions as an independent force exerted significant adverse influences at the microeconomic level on the availability of new loans for Russian banks and firms in foreign capital markets and indirectly contributed to capital outflows and reductions in FDI. But the macroeconomic effects of sanctions probably have been small, in part because they are being offset by Russian counter-measures. Overall, sanctions are having negligible effects on important economic and military power balances or on the decision-making of the Russian elite concerning national security matters, such as the status of Crimea.

Similar conclusions can be drawn about the impacts of Russian sanctions on Ukraine and the EU. The faltering macroeconomic performance of Ukraine has been caused primarily by accumulating problems (high external debt), the direct economic effects of the crisis (disruption of industrial production and tax collection in the East), and normal reactions of foreign investors to geopolitical risk (depreciation of the currency). The loss of Russian subsidies has been offset by increases in IMF/EU/US support and Russia has permitted many economic exchanges (including those concerning energy) to continue. Russian counter-sanctions have had negligible macroeconomic effects on EU countries because the affected commodities (food products) comprise only small shares of exports, but there have been some important negative microeconomic impacts (e.g. the bans on the exports of fruit from Greece, apples from Poland and cheese from Lithuania).

Conclusions: Implications of Findings for EU Policy

The analysis above has produced answers to important questions, such as: Has the economy of Russia been adversely affected by economic sanctions? Due to space constraints these cannot be summarized here. Instead attention is focussed on relating findings to three questions of concern to EU policy-making in 2015.

(1) How generously should the EU support the reform and recovery of the Ukraine economy in light of budget constraints and the austerity policies of several EU member states?
The European Commission (EC) did not anticipate that its attempts in 2013 and earlier to develop closer relations with Ukraine through the ENP without taking into account Russian interests would help to initiate the current complex political, economic and military conflict. The EU, US and IMF have taken over responsibility for supporting the flawed and failing Ukraine economy from Russia. The IMF already is providing Ukraine with a financial aid package of $17 billion, but much more (perhaps $30 billion) will be needed. The EC has not provided EU citizens with a full explanation of events and their unintended financial implications for taxpayers. Given the current tensions within the EU between Greece and the Troika over the austerity policies and bailout loans, as well as the difficult economic circumstances of other countries (e.g. high youth unemployment in Spain), it is not certain that a democratic consultation of the population by the EC would reveal significant support for a major allocation of EU funds to help Ukraine. However, in order to avoid governance difficulties in the future, it would be best for the EC to be consult EU citizens before it makes firm financial commitments to Ukraine. The EU also should be careful to ensure that any financial assistance provided to Ukraine cannot be used as defense expenditure to finance a military build-up. Given the high debt level of Ukraine and the inadequacy of budget revenue to cover constitutionally-guaranteed basic social needs (medical care, pensions, education, social care), any funding to support the improvement of the long-neglected armed forces has to come from foreign sources.      

(2) Should the EU de-couple its economic sanctions policies from those of the US if the Minsk II accords are largely honoured by both sides in the conflict?
With any economic sanctions it is important that the terminal conditions be clearly specified and be achievable. With respect to Ukraine, there are important differences between the EU and the US on the endgame. It appears that a majority of EU member states (and probably of EU citizens) would be satisfied with a peace settlement that would ensure that there would be no more war in Ukraine, that appropriate powers be devolved to regions, and that the central government regains control of Ukraine’s borders, not including those of Crimea. The Crimea issue could then be treated in a manner similar to the Baltic states in the Cold War. In contrast, the US has set the return of Crimea to Ukraine as a non-negotiable condition for ending sanctions. But Russia has made it clear that it never will do that. So the US is locked into economic warfare of indefinite duration with Russia, especially given the current political composition of the US Congress. In light of the facts that the US has insignificant economic interests in Russia, whereas the EU countries have substantial stakes (imports of energy, exports of consumer and industrial commodities), it would be sensible for the EC to make contingency plans for a decoupling. On the basis of the experience from the 1980s when West Europe ignored US sanctions related to the gas pipeline and of the mutual dependence of the US and EU, it can be anticipated that there would be only short-term strains in the relationship following a decoupling.

(3) Should the EU discourage the NATO from providing military assistance to the Ukraine armed forces?
The poor performances of the Ukraine armed forces in the two active phases of the war reflected the neglect of them by successive governments over two decades. The military power balance in Ukraine now is firmly in favour of the insurgents in the eastern regions and their supporters in Russia. These circumstances cannot be changed in the short-term, especially not by foreign powers providing more sophisticated weapons and military equipment to Ukraine. Over the decades the US has had little success in supplying weapons to weak governments with poorly performing armies, which describes the situation in Ukraine. US weapons are only effective if they are used by properly trained and motivated soldiers and are well maintained in a technical sense. They are appropriate for NATO armies and a small sub-set of other allies, notably Israel. The armed forces of Ukraine would require intensive and extended training before they could handle some of the systems (e.g. the AN/TPQ-53 mobile anti-artillery radar system) being proposed by supporters of arms supplies. A further complication has been highlighted by President Poroshenko: Ukraine government, intelligence and military organizations have been comprehensively penetrated by Russian intelligence. So the insurgents and the Russians would know the numbers and locations of any NATO-supplied military systems. A final problem is that Russia has escalation dominance in conventional weapons, which means that that the US cannot alter the military balance in favour of Ukraine, even in the medium term. In sum, European countries would be acting sensibly to discourage the US from getting involved militarily in the Ukraine conflict.

Christopher Davis
Reader in Command and Transition Economies, Department of Economics and School of Area Studies, University of Oxford, academic specialist on the economy of the USSR/Russia, especially industry, defense and health.

See also:

 Christopher Davis. The Ukraine Conflict: Economic-Military Power Balances and Economic Sanctions (RIElcano TV – 7:41)

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[1] This analysis relates to Davis, C. (1990), ‘Economic influences on the decline of the Soviet Union as a Great Power: Continuity despite change’, Diplomacy & Statecraft, p. 81-109.