The Perils of Financial Warfare

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.

Nicholas Mulder is a graduate student in the history of economic thought and political economy at King's College, Cambridge.