16: Russian Sanctions. Weaponised Economics.

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Female voice: Welcome to Burgernomics, demystifying economics with Ross MacDowell.

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Ross MacDowell: Hi, everybody. I'm Ross MacDowell and welcome to the Burgernomics podcast where we demystify economics. The world is reeling from the largest conventional military attack in Europe since World War II. Russia has invaded the Ukraine. Just about every country in the world is outraged about this invasion with China sitting on the fence but unlike other wars, all the countries opposing this war have decided not to fight head-to-head with the Russian aggressor.

Is this because they fear Vladimir Putin has forgotten the theory of mutually assured destruction, meaning Putin's threats of nuclear missiles against the West would start a nuclear war where everyone ends up dead? Led by the United States in Europe, economic sanctions are now the weapons of choice against Russia rather than missiles, warships, and fighter jets. The West believes it can economically sanction Russia into surrender but just like bombs and missiles, economic sanctions too create collateral damage.

To discuss the effectiveness of weaponizing economics, I'm joined today by Steven Hamilton. Steven is an assistant professor of economics at the George Washington University in Washington, DC, and a visiting fellow at the Australian National University. Steven has authored policy proposals for the Brookings Institute and provided economic cometary for The New York Times, The LA Times, and Time Magazine. Steven, welcome to the Burgernomics podcast.

Assoc Professor Steven Hamilton: Hello, Ross.

Ross MacDowell: Now, Steven, are we all of a sudden seeing economists sitting beside generals in the war room at the Pentagon, can economists subdue countries as effectively as Generals?

Assoc Professor Steven Hamilton: It's a bit of a scary thought, isn't it? [laughs] I have to say, I never expected to be talking about military action as an economist but here we are. That's a lesson to anyone, any young person who's thinking about getting into economics, just how broadly applicable economic principles and economic policy are. We belong. I get attacked frequently about wandering outside my lane but economists have just about the widest lane there is, I think so.

Look, sanctions have been in place in Russia for some time. They were used against Russia following the annexation of Crimea back in 2014. This is not new. In fact, the Russian government and the Russian people have adapted to a series of financial sanctions that have been imposed on Russia by the West. Mostly, they've been confined before this point to certain individuals, certain businesses. They've been somewhat confined, and again, the Russian economy and the Russian financial system have been able to adapt to them. They haven't been crippling. Plus, you've got to imagine the Russian people are pretty resilient, pretty hardy people and so they've struggled through.

Now, this latest conflagration has led to a significant escalation in the intensity of sanctions. It's now become rather than simply being a kind of punishment, it's now become a very serious military-like tool that is really being used to try and prevent further escalation by Russia. In that sense, yes, the economic tools being employed are like tools of war and should be considered as such.

Ross MacDowell: Russia probably also has similar thoughts because they built up a $630 billion US war chest planning for this invasion. That included 2,300 tons of gold. Half of that amount of assets were deposited in overseas banks for safekeeping. Most of it in overseas central banks. As we've said on previous podcasts, central banks are always considered to be independent of government to give them credibility. Yet, this is the first time that central banks collectively around the world have said, "No, we're not going to release your assets because you are going to use them for war." That, in itself, has the effects of starving Russia of the cash flow needed to finance its military operation, to finance its own economy. It would appear that they too were ready for this.

Assoc Professor Steven Hamilton: It's fascinating. At the start of the war, just a few weeks ago, we had word of Western governments coming together to organize sanctions. Initially, they looked like they would be more of the same, right? Just an expansion in a [unintelligible 00:05:42] of the existing style of sanctions used since 2014. At that point, I was concerned the West wouldn't do what was necessary to prevent Putin from escalating or from invading because there are nuclear power. We don't want to engage in a full-scale war with them because we know where that will lead. Putin knows this and we'll use it to his advantage and we'll just roll over. That didn't happen. Not only has the West been incredibly united on the military front and provided 17,000 [chuckles] portable missiles of the Ukrainian military or 17,000 missiles.

The West has also cooperated on really unprecedented economic action. Economic action that, I think, we didn't, as Western economists, didn't imagine. Within a few days, things that I never thought were possible became possible, but also actions, which I think Putin and the head of his central bank Elvera and Navilina, I'm not sure of the pronunciation, I'm not Russian but I don't think anticipate it. As you quite rightly said, traditionally, we think of central banks as sacrosanct as beyond the realm of these kinds of actions. Now, in a few isolated cases, Iran, Venezuela, Afghanistan, we have taken action against central banks, but it's very isolated and certainly, never of the scale of Russia have we contemplated this kind of intervention.

I think Russia thought that those were the rules, that central bank would be on that. In anticipation of a continuation of the existing sanctions that they've endeared since 2014, they built up this war chest of $640 billion. It's nearly a trillion Australian dollars of foreign exchange reserves, which you can think of as really like Putin's piggy bank. A giant cash pile that he can do with what he likes, including: continue to fund the government in a period in which maybe the government has trouble borrowing because of sanctions, or he can buy rubles to support the currency if there's capital flight out of Russia that causes the ruble to plummet, they can use those reserves to buy rubles and prop the currency back up again, so that they can continue to function.

This stockpile of cash was meant to provide Russia with exactly the stability through these sanctions that they need but what they didn't count on is the West coming together and freezing those foreign exchange reserves. That's a unprecedented move. They have a huge amount of gold but a lot of it is in foreign exchange reserves held by foreign central banks. Places like the Bank of England, the European Central Bank, the Federal Reserve, they hold Russia's assets and allow Russia to draw on them to go out and do what they need to do. That's what's been frozen.

This war chest, they built up that they expected to dip into to deal with the crisis has been cut off. It has really limited their ability to stand against it. It's backed them into a corner and the hope in doing this among the West is twofold: one, it's just an incentive. We can go into this in a second. It's going to crush the Russian economy and that's very, very bad for Putin and the Russian people, but also, it literally makes it harder to continue the war effort because the war effort requires finance. Without finance, how do you build military equipment? How do you pay foreign fighters to fight in your war, et cetera, et cetera, et cetera? There's a direct financial lifeline that you're trying to cut off through these sanctions.

Ross MacDowell: Let's just look at what some of these specific sanctions are and how they'll affect the Russian economy. The number one sanction appears to, again, be a very specific economic sanction which is banning Russia from the SWIFT system. Can you just explain what the SWIFT system is?

Assoc Professor Steven Hamilton: People don't need to know too much other than SWIFT is a esoteric electronic system, which notifies foreign intermediaries of a financial transaction. Whenever you have trade of goods and services across borders, to go with that trade of goods and services, you need a flow of funds. Money has to pass from one country to another, from one financial institution to another. The SWIFT system is what's used to notify financial institutions that that trade is occurring.

If you cut that messaging platform off which-- the SWIFT is located in Belgium, I think, and with the coordination around the world, we can cut countries off, that makes financial transactions in and out of the relevant country very difficult or impossible in certain circumstances. I think SWIFT is important, but in my view, it's not the most important, partly because the way the SWIFT ban is enforced, there are lots of carve-outs. There are other ways to transfer funds outside the SWIFT system.

There's talk, for example of Russia using the Chinese transfer systems. It's important, but I wouldn't say it's the most important. It's certainly got most of the mind share and the way people have understood it. I think there are other things that are more important. The other thing to consider, of course, and I'm sure we'll go more into this later. The financial system is highly interconnected. It's not like you can just switch things off and on and expect that to be the effect. You start switching things off and on in certain areas and they have spillovers to other areas.

I think, partly, the effect of the SWIFT ban isn't so much on the transactions itself, that it bans, but on the spillovers to other transactions in the financial system. There are financial institutions, which are just saying, I don't want to fall foul of this thing. I'm not in even going near Russia at all. All business with Russia ends. That's the big impact that we're seeing from the sanctions.

Ross MacDowell: What are the other specific sanctions that you see as having the intended effect on Russia to create a pressure to stop this war?

Steve: The one that gets the most and public impact is the direct targeted sanctions on individuals. I think that's overrated in the sense that, I think, there's a perception in the West that Putin is at the behest of the oligarchs in Russia. That's not the case. [chuckles] Putin has a lot more power over them than they have over him. If Putin goes, they will go too, they'll end up at jail, maybe they'll be executed. They need him more than he needs them. Everything I've read everything, everything I understand I'm skeptical as to the effect of that. I think of that more of just a punishment.

Ross MacDowell: I noted that the 500 richest Russians control 40% of all Russian household wealth, meaning they're three times wealthier than their counterparts in the Western world. I can't help but thinking what real power of the oligarchs got, it's not like they're a group of people that are going to organize a coup to get rid of Putin,-

Steve: No.

Ross MacDowell: -and it's not like Roman Abramovic is going to be hugely disadvantaged having to go from four huge private jets down to two, or he has had five superyachts at the one time. I think he's down with two at the moment. I can't see these people really hurting to the same degree as the people, perhaps, queuing up for bread and sugar. Do you think the ban on all of these oligarchs is more symbolic than a practical?

Steve: It's PR. It's PR by the West to try and get public support for the action. It has just broad appeal. You go after those fat cats. Great, everyone's on board. As I said, I don't believe it will make a difference. I think apart from anything, so much of this wealth is hidden. We believe Putin has something like $200 billion worth of wealth personally, but we don't know because how would we know? It's hidden, and because it's hidden it means it can escape the sanctions. I think it's been hyped, but I don't think it's the most important thing. I think there are bans on transactions. There are bans on people dealing with certain Russian firms and certain Russian financial institutions.

For example, when I say that the assets of the Central Bank of Russia have been frozen, something that people may not realize is that the-- Not only did the US government freeze the assets of the central bank, they made it a crime for any US citizen to interact with the Bank of Russia. Literally. Any American in the world who wants to engage with the Bank of Russia, they're committing a crime. We're talking serious pariah status for the Russian economy. That means that even if the Bank of Russia has gold and it wants to go out and buy foreign currency with that gold, who's going to transact with them?

Any American in the world can't, it's illegal. It just dumbs up the system and makes it very hard for Russia to function. Now, why does this matter? What we got to think about is financial flows into and out of Russia and how these sanctions affect those financial flows. Russia has a current account surplus, which means they export more value than they import. They are a big commodity exporter. They export oil, coal, gas, wheat, canola, I think, fertilizer, and a bunch of precious metals. They're a big commodity export and not unlike Australia or in that sense. They export a huge volume of these raw materials, but they also import a lot.

In fact, many of Russia's domestic industries are heavily reliant on both imported physical components and imported IP, the know-how, the technology. What these sanctions do is they cut off that flow of finance. Therefore, the flow of goods and services and IP going into Russia. It's like a siege, you're cutting the Russian economy off from all of the things that feed it and make it very difficult to function. Then what we're also doing is we're taking away the tools that would help the Russian government to combat this. The two effects mean, Russia's economy becomes isolated. They have no ability to buy imports. They have no ability to buy foreign technology. For example, if you want to build a Russian missile to shoot at Ukraine, that missile has a microchip in it.

If that microchip has American IP, which it almost certainly does, then they're not allowed to buy that chip from anyone, including China. They can't build the missile. They can't shoot the missile at Ukraine. It's not just defense production. The biggest Russian car company Lada has shut production because they can't get components to put into their cars. The Russian airline industry has shut down because almost all the Russian fleet of aircraft are Airbus and Boeing, and they no longer have access to parts, or the manuals necessary to install those parts. The Russian near airline industry is ground to a halt.

If you think about the implications of these sanctions in cutting off trade with Russia in the world, they are crippling. Crippling to such a massive scale that the economy can't function. You've got mass unemployment. We're seeing hyperinflation, we're seeing a bank run. The real effects on the Russian economy as a result of the sanctions are really dramatic. With every day, they'll get worse.

Ross MacDowell: These things are happening now. In economics, we always talk about the lag effect. In modern warfare, you drop a bomb, fire a missile, it's very instant, the effect, but economic has lag effects and sanctions have lag effects. From what information I certainly have, the price of milk's already doubled in the past two weeks in Russia, sugar, and cereal prices have gone up 20% already. Stores are restricting purchases by consumers of flour and sugar and oil. This reports of hoarding, the overseas food chains that shutted their stores in Russia, before they shutted them, they were selling their uncooked food for up to 10 times the usual price.

Medicines which aren't subject to sanctions are going to be in short supply because the shipping companies won't want to ship them. TV's are up 10%. Outgoings for businesses, such as rent and cleaning, up 30%, even just, I was reading about a language school, said, "We can't pay our teachers that are using Zoom, who are located in foreign countries. We can't make those transfer payments to pay them. We can't even pay for Zoom to be able to use that." I guess for those older, they can feel a return to the days of the Soviet Union before it disintegrated, where the economies were beginning to collapse causing the disintegration of the Soviet Union.

The younger people can't realize that, they didn't live through it. The older people can and there's this fear of returning to the Cold War. Russia gets 40% of its state revenue through its oil and gas export sales. With real impact that it's having, will it work? because similar sanctions haven't worked on North Korea, Venezuela, and Cuba. No regime change ever occurred in those countries with the same sanctions. Are we being too optimistic by expecting Putin to be overthrown or for him to give up on the war? What's your opinion on that?

Steve: There's a bit to unpack. First is, we haven't set out the objectives of these actions. [chuckles] I've never heard a Western officials say, "Here is the goal. Here is the goal, here is how we expect Russia to respond. If Russia responds in terms of X, we'll respond in terms of Y." We don't know any of this. It's not actually clear what the objective is. It's even hard to judge whether it's effective because what was the point?

There is some disagreement among commentators about whether it's a punishment, X post punishment for a long dynamic in terms of long dynamic incentives. Regimes know that if they behave badly, they will be punished so that will deter future action, or whether it's short-term deterrence. Whether we are actually trying to achieve regime change or lead Putin to withdraw or compromise or whatever. Among commentators, that's not agreed.

Now, let's roll back a little bit. We started to say, "What's the timeframe over which this will affect things?" The first thing is every single day they ratchet up. Now, modern economies, Russia is just highly integrated into the global economy. A lot of just in time inventory management is used, so this makes supply chains very brittle which is fine if the global economy is open and functional, but as soon as things stop, it doesn't take very long for a crisis to emerge. I'm to understand that, for example, the Russian airlines keep about two to three weeks apart on hand, and so you cut those parts off, they can fly, but within two to three weeks they start to need parts and they can't function any longer.

We've already seen a lot of the car companies shut down. We're already seeing the sanctions bite, but inventories across the economy will start to drawdown. With every day, some business somewhere will grind to a halt. With every day and more and more and more output is lost, and so that begins to bite harder and harder and harder. To think of scale, if a country loses 5% of GDP, its income, its production in a year, that would be a very bad recession to lose 5% of your economic output, while Russia's forecast to lose 30% of GDP this year. [chuckles].

Ross MacDowell: [unintelligible 00:23:11].

Steve: That's depression level crazy collapse, and it's not a surprise because we've crippled their economy, of course, they're going to collapse. Now, that has all sorts of effects on real people. The ruble has fallen, I haven't checked since late last week, but when I checked the last data, it was down 40% compared to a month ago. A 40% reduction in your currency is extraordinary. It means that dollars in the bank are now worth half what they were worth before. That's pretty wild, so if you had savings in bank account, they've halved their value in a month. That's a serious problem, or the price of imported goods has doubled is the other thing that means.

As you noted, we're getting inflation, so with all sorts of goods are rising in value. As some production will shut down because they can't get imported inputs, production alternatives that rely less on imports are more scarce, they rise in value. There's no way to escape the inflationary pressure. You get a collapse in the ruble, you get an increase in inflation, and that increase in inflation creates lots of really concerning issues inside the Russian economy. It leads to, as you said, hoarding, people don't want to use cash, they start bartering. Anyone who countries that have experienced hyperinflation, Argentina, there's lots of historical examples, Zimbabwe. Economies cannot function in that environment.

That's where we're heading with Russia. Now, the Russian Central Bank and the Russian treasury did a bunch of things to try and stand against this. They raised interest rates from 9.5 to 20%, which seems crazy because you're going to go into a recession while you're doubling interest rates. Well, that's to stop the inflation because if you raise interest rates, you're making it more beneficial for people to hold savings, less likely to pull their money out. You're trying to press against that inflationary pressure. This is the conundrum Russian policy architecture finds itself here. It's got, on one hand, a collapse in the currency, massive inflation, financial crisis. On the other hand, it's got an economic collapse coming.

You can't do both. You can't lower interest rates to boost economic activity and raise interest rates to stop inflation. You can't do both. There is no escape, no matter what the Russian government does from pretty massive economic collapse. As I said before, that's going to have profound effects on the Russian people. Think, so now, we're back to the final question, which is what effect will it have? Well, nobody knows. I don't know, foreign policy experts don't know. Here's the only thing I will say. I'm not convinced, I'm not convinced that it will put pressure on Putin to change course directly in the sense that there's huge public support by the Russian people for this invasion stunningly because of the degree of misinformation.

Also, things like nationalist pride in Russia. I'm not sure that the Russian people will blame Putin for these sanctions and the economic hardship rather than NATO. It's not obvious they'll call for Putin to go if they're hurting economically, "It's not his fault," this is what a lot of people will think. The path to capitulation by Putin due to the sanctions, in terms of incentives, is not clear to me. What is clear is the sanctions will make it harder for Putin to wage war.

That is a very practical channel through which the economic sanctions hurt Putin and Russia. It makes it harder to win. One of the nice things is Ukraine has been so steadfast. They've held out so much longer than we expected. Supported by the West in terms of arms supply, but they've been so effective in holding the Russian invasion at bay, that this is dragging the war out longer. With the effect of the sanctions, the longer the war goes on, the harder it is for Russia to fight it.

We're already seeing Russia use very limited guided missile attacks, for example, because they don't have enough missiles. There's all sorts of areas in which the Russian military will simply not be able to fund and provide physical resources to continue the war effort, and the sanctions help hasten that. At the end of the day, if Russia is going to lose the war, that's very concerning to Putin, his legacy, his regime, he may capitulate to save face. The sanctions help hasten that process. I think that's a practical channel through which this could make a difference.

Ross MacDowell: Okay. Let's talk about collateral damage. Just as bombs kill the enemy, and also inflict terrible wounds on innocent civilians in the vicinity of an explosion, it's the same with economic sanctions. The world will suffer the economic fallout of these sanctions. Just looking at a few things and the first one that comes to mind is oil. The world uses 100 million barrels of oil a day to run the economies of all of the countries and the world. 7.1 million of those barrels come from Russia.

To put that in perspective, during the Gulf war, 4.2% of global oil production was at risk, but with this war, if we put in Ukraine as well, 8.1% of the total oil needs daily are at risk. The world buys $1 billion of Russian fossil fuel every day, and 500 million of that every day goes to Europe, which amounts 2/3 of their energy needs. Russia supplies more than a quarter of the world's needs of the liquified natural gas. Germany had planned to phase out nuclear power and their coal energy power plants replacing them with Russian gas by 2030, obviously, not now. Ukraine and Russia account for 25% of the world's wheat trade, 20% of corn trade, Russia supplies 90% of Poland's coal, Russia and Belarus supply 40% of global potash production. The price of that has already gone through the roof worldwide. What's that going to do to farm input prices around the world? Russia supplies 12% of the world's platinum, 8% of the world's aluminium, foreign investors hold $40 billion of Russian debt receiving no income because those Russian bank transfers have been frozen.

As we've mentioned, these sanctions amount to dramatic commodity price increases and shortages, they're going to create even greater inflation than what we are already experiencing, especially in the US, which will lead to a possible recession. Maybe even the equivalent of a deadlocked war would be that in economic terms, stagflation. The one thing that all economists fear. Are just shooting ourselves in the foot with these sanctions against Russia. At the end of the day, yes, they certainly going to have dramatic effects in Russia, but boy, they're also going to have incredibly dramatic effects for the rest of the world.

Steve: It's a great question, I wish we had three hours because [laughs] there are so many issues to talk about so let's try and break it down a little bit. The first thing is the sanctions harm Russia more than us. That's the first thing, right? Which is why we use them. I mean that's how war works, right? You want to use tools that cost your enemy more than they cost you and if you have a huge asymmetry in those costs, you can win the war.

That's the case with the sanctions, now because there's a hierarchy of sanctions, there are, depending on what you choose, things that can hurt you increasingly more, right? That's why these sanctions have followed a ratcheting process. We started with things that hurt us hardly at all and we've progressively escalated to sanctions that hurt us more and more and more and more.

I think that's appropriate, It's stupid to just go nuclear straight away. It makes sense to escalate. Before the Russian crisis even began, the world was experiencing inflationary pressures that it hasn't experienced since the seventies, the US inflation is at about 8%, which is crazy. I mean, usually, we think of inflation at 2% to 3%. In fact it's been less than 2% lately, right? Pre-pandemic so inflationary pressures have been very high. Partly, I mean, mainly frankly because we were coming out of, a pandemic, which caused huge economic dislocation but also because there was massive stimulus at the time of the pandemic, which was good, but in some cases excessive and that just further fed these inflationary pressures.

Ross MacDowell: With quantitative easing.

Steve: Literally, I mean, the US government handed out just extraordinary amounts of cash stimulus way more than really was necessary so we probably definitely overdid it. We know we overdid it, but regardless those pressures were there and those pressures were political problems. I mean, they were economic problems, but they were also political problems.

Joe Biden was having a hell of a time politically before the invasion over this cost of living issue, people do not like inflation. They hate it there's money illusion, they don't really think carefully about real wages, cost of goods are going up, but my wage is going up. They don't think about this they just see, "Holy cow, this thing rose by 20%, how terrible, right?" Gas prices were high, all sorts of political problems were there.

It's hard for me to imagine that Putin wasn't opportunistic in timing this intervention, because it didn't take a rocket scientist to know that no matter what the West did, the invasion of Ukraine would generate massive inflation. Right? I mean, in terms of oil prices, other energy prices, food prices all across the board. I imagine he anticipated this and the harder the West goes to try and fight Putin.

The more pressure is put on some of these prices impacts, the harder politically it is for leaders in the West. I think he knew he was boxing these Western leaders into a corner. Now, thankfully I think the West called his bluff and said, "I don't care, mate. We are going to fight you, even if we caught some flak."

There was a wonderful media release by Joe Biden that's said, "Question, will this oil embargo that you're putting in Russia increase gas prices?" He said, "Yes, absolutely it will and you have Putin to blame." I think that's exactly the right approach, right? That at the end of the day, the world needs to take actions that are righteous and if they cost something, that's a cost we need to be willing to pay as liberal democracies in the world. In Australia, Josh Friedberg has made similar statements recently.

They seem to be handling and I think, I mean, voters don't like high prices, but I'm not sure they'll punish politicians when they perceive those costs as being imposed by our enemies. I think in some sense, that's handled, but in terms of the economic impacts, you've laid it out beautifully. I think that's exactly right. It's very bad timing for the world to be suffering even more inflation and shortages of certain goods just at a time when we're emerging from the pandemic and having a bit of a struggle trying to manage things.

I think even though oil and other energy have been excluded from the sanctions, we're already seeing that those like oil futures are having trouble selling at big discounts, for example, because there's always spillovers and fall out, even if you're trying to exclude things. There's not really a way to step up against Putin without bearing cost Certainly, so far to my mind, I think it's a cost that's been willing to pay now, the thing that's worth mentioning is should we go further? I do think further escalation will involve much higher costs and I think the thing that a lot of people are talking about at the moment is an embargo by Europe, on Russian oil and gas, right?.

Stopping those exports, which would cut off Putin's final financial lifeline entirely and, and make it even harder for him to continue in the war but that would start to, Europe and in particular that there are spillovers to the rest of the world would start to incur really significant costs. That's something that I would be very cautious in engaging in. We certainly shouldn't be flippant about it. I think we should be realistic about it. Especially if we think that Putin's all in and anything more we do in economics isn't going to make any difference then shooting ourselves in the foot isn't really worth it.

Ross MacDowell: You are also saying Putin's quite rational. A lot of people have painted him as being maybe a madman, but you are saying he's very well considered. He's figured it out, especially not militarily, but just as much economically,

Steve: I think he's rational, but he had bad information so one of the things we are learning is that despotism is a terrible form of government, right?. [laughs] The Russian political system for a really long time, but certainly since the early nineties with the fall of the Soviet Union, it's been built around corruption. It's a fundamentally corrupt system of government and autocracy, despotism, corruption.

All of these things are terrible in terms of their insidious effect on the economy and the political system, for example, I think Putin believed that his military was far more capable than what it was because he was told that it was, right. There's like it's turtles all the way down. It's corruption all the way down, right? And if you don't go to war, you never really know that the military isn't capable and people promise you it is. You go to war and then you realize, whoops, that was a mistake, right? The same is true everywhere through the Russian economy.

I think Putin believed based on the information he was given that his economy was far more resilient to sanctions than it was that put a lot of work since 2014 into import replacement. Domestic substitutions for imports so that if imports were cut off, they'd be able to continue to function. It turns out that's not true so I think Putin made a calculation based on bad information, bad information that came from the fact that he created a system of autocracy that builds incentives into giving bad information. He's not an idiot, but I think he probably ought to not have trusted people the way that he did.

Ross MacDowell: Let's talk about the elephant in the room, the other big economy, China. How do you see China figuring into this conflict?

Steve: Yes, it's a great question, so China, it's the one that I get masks most of all. I think the world ought to be looking to China very carefully to see how they go. To date they've been on the fence, as you said earlier, right? That they're in a really sticky position because I think it was two weeks before the invasion, Xi and Putin signed a forever agreement to be allies forever, that was a concern and clearly was signed with foresight to this intervention, so we have reason to believe that China knew this was coming. China is allied to Russia.

The other issue is, I think, by all accounts, Putin passed some of his excessive optimism across to Xi. I think Xi expected this to go easily, be over and done with within a couple of weeks, and I don't think any of them anticipated the sort of, I don't want to swear, the kind of epic disaster that has resulted from this. I don't think they anticipated that, and so now China is in a difficult position. Do they back their ally in Russia, or do they look at the rest of the world and go, "Well, we don't want to be any part of this"?

One obvious concern is that the Chinese are sanctioned, somehow the Chinese economy falls under the umbrella of the economic sanctions that we've imposed on Russia, that would be very bad for China. Chinese economy relies very heavily on exports, so they can't have any disruption to their production chain. If IP coming into China from the US was blocked, for example, even in a limited sense, that would be very damaging to the Chinese economy. The Chinese have reason not to want to be anywhere near this.

While most of the commentary has focused on China being allied with Putin, what I think is interesting is that they've been maybe more independent than you might have expected, certainly more independent than you would have expected based on that pre-invasion agreement that they signed. I actually take that as a sign of the Chinese wanting to put distance between them and Putin, and that's good.

Moreover, I think the rest of the world, including Australia, needs to do whatever we can to encourage China not to connect with Putin, not to provide him with assistance, not to provide him with any kind of lifeline. I don't know what that means, but to the extent we can extend an olive branch to China to try draw them away from Putin, I think that would be good.

Maybe some thawing of the frozen relationships between China and other countries like Australia would be in order, because I think the last thing the world needs is pushing China into the arms of Russia at a time like this. That's the concern for me.

The only other I would say is we are already seeing Chinese firms not provide finance to Russia because they don't want to get caught up in the sanctions, it's a mess, so I don't think that China will be a lifeline in the way a lot of people think. Also, it's impossible for Chinese exports to replace everything that Russia gets from the West because again, a lot of these exports involve American IP and other things, and you can't just switch overnight. I don't think China will be a lifeline. I also think, diplomatically, China will be very careful not to weight in because they don't want to be on the wrong side of this.

Ross MacDowell: On two occasions in the podcast so far, you've talked about IP. I know that there are going to be so many people listening to this podcast that are going to ask this question. You talked about IP, maybe going into ships, into missiles in Russia, and similarly, IP going into China. If the West sees Russia as being a country of concern for decades, as it has China, how does the West export IP to these countries of concern so that they can arm themselves? Why wouldn't they just have a direct prohibition of exporting any intellectual property to these countries, which are considered potential enemies?

Steve: There'll be a lot of people coming out of this crisis who will do a lot of internal reflection [chuckles] about all of the mistakes they made over the past couple of decades. I think there was a hope in the West that, and this story applies equally to China, openness to the world economy would bring economic growth, which would make the middle class richer, which would drive liberalization of these countries, to push people towards more liberalism, more freedom, more individual choice, democracy. That's, I think, the hope of the West from the fall of the Berlin Wall onwards.

Unfortunately, in both Russia and China, we've seen exactly the opposite, which is we've seen the rise of these two autocrats, which in the last 10 years have taken significant steps away from liberalism. They've withdrawn from the liberal order, and that's a real concern. I think in some sense, connecting to China, again, connecting to Russia, providing them with technology, investment, that all was based on the expectation that these countries would, over time, become more free. That, I think in a big way, was a mistake.

It's amazing that in Russia, in 1998, there was a huge financial crisis, sovereign default, a lot of very bad outcomes. That wasn't that long ago, 1998. After that, there was lots of foreign investment, lots of people giving the Russian government finance to run its operations, buying bonds, et cetera, lots of integration, because they thought, "Oh, no, the trajectory of history is towards more freedom, more liberalism. Everything will go back to normal."

Well, that was a mistake. There'll be a lot of foreign firms who are going to get very burnt from this. I think BlackRock is a large hedge fund that they've written their assets down by $17 billion or something based on this. I think there'll be a lot of people who made a lot of mistakes, and I think that what that means is two things. One, it's hard for me to imagine the effects on the Russian economy won't be permanent. Fool me once, fool me twice, I think we're in a fool-me-three-times situation, that they won't do it again. I think the notion that if this just goes away in six months, everything in Russia goes back to normal, foreign money will flow in, I think is very unlikely. In other words, Russian impairment is probably permanent.

The other thing is, I think there'll be a lot of rethinking about China, so huge foreign investment in IP and other things in China. I think there'll be a big focus by foreign firms to diversify away from China's production and rethinking of relationships with China, thinking forward to a time where maybe China invades Taiwan, or does something else that the West doesn't like, in other words a replay of this crisis but in the Asia Pacific. I think both things are going to lead, in both domains, we're going to have a big rethinking of integration with these kinds of regimes.

Ross MacDowell: Let me ask you this question. You've got thousands of innocent civilians currently being slaughtered in the Ukraine, a war happening that's creating that situation. That's very instant. World-changing sanctions that will economically affect everybody in the West, but even to a greater extent, Russians that are going to go through food shortages and hardships, but that's not as instant as people getting slaughtered in the Ukraine.

As you've said, no firm objectives have been set out for these economic sanctions that are replacing missiles and warships. What's your timeframe for what you think is going to happen? What do you think is going to happen, and when do you think it's going to happen?

Steve: [laughs] Asking an economist to predict the future is a bit of a worry. [laughs]

Ross MacDowell: Hey, you're as good as the generals in the war room [crosstalk]

Steve: Yes. Exactly. Exactly. We usually think of it as a random walk, but anyway. I would say it's better to think in terms of possibilities. "What are some potential futures that we might see?" That's fine. A lot of focus has been put on Putin saving face. It's something I tweeted a couple of weeks ago, looking at Putin being in a corner, a sort of wounded dog in a corner is a very dangerous thing, so is there some way that we can give him a way out. Or, there's this famous proverb from The Art of War, I think it's like, "Build your enemy a golden bridge to walk over." Is there something we can do that lets Putin save face, and what might that be?"

Certainly, one thing that would be good, which we haven't seen from the West, is a clear set of criteria that would allow for the loosening of the sanctions. What do we want from Putin, specifically, in order to start reducing the effect of these sanctions? That's something we don't have, that I think if we were to put in place, might help him see a pathway out, so that's one.

Two, it depends significantly on what happens in Ukraine. Right, so, because the Ukrainian military has been so effective in preventing this Russian invasion, it's extraordinary couple of weeks in to be where we are. I don't think anyone expected this.

The Russian military has essentially failed at any objective it had, completely failed, right? They've managed to bomb a few cities into oblivion. They've killed a lot of civilians, but they've probably lost more than 10,000 men in this assault. They've lost thousands of pieces of military hardware, right? The military costs on Russia are tremendous, right? The sense is they can't sustain these losses for weeks, let alone months and so the question is, if we continue to be effective in supporting Ukraine to withstand the Russian invasion, the longer it goes on, the more pressure there is on Putin because he literally can't win.

Right, and so that's where these off ramps may come in handy. Things that we might look for, something we already see is in the new round of negotiations, the conditions given by Putin are somewhat weaker than they were earlier, right? That's a good sign because their position is worsened, right? We want to continue to push down that pathway.

One obvious outcome would be Ukraine accepting the annexation of Crimea and maybe the Donbass region and agreeing not to join NATO for example. Right, if it just tick, tick, tick, Putin can say, "Well, I've got what I wanted, I withdraw." We loosen some of the sanctions. The question is, will Ukraine accept that, but there's potential for that outcome. That depends on how long Ukraine can hold out, how successful they can be in the war from now on.

Now another possibility, and this is something I'm very concerned about is the notion that Putin is in a corner. We've put these crushing sanctions on him, he's losing, he has things he can do to win and I'm not sure that NATO will intervene. For example, could he use chemical weapons in Ukraine or could he launch a tactical nuclear weapon on a small Ukrainian town or city? What would that do to Ukraine and how would the West respond? Well, if Ukraine would surrender and the West decides to not get involved because they don't want to enter World War III, Putin would win, right? That's the concern is that we have escalated this thing so much.

We have put Putin in such a tight corner that he might be increasingly reckless in order to get out of it, be willing to take very large risks if it means getting out of it, and so that for me, they're the two extreme possibilities, right? We find Putin a way out, we get a safe face saving scenario or Putin continues to be isolated and does something crazy. Which of those will happen? I have no idea, but they're the sorts of outcomes I think we want to be thinking about

Ross MacDowell: Now, Steven, not to trivialize war, but at the end of all of the podcasts, I ask my experts to encapsulate what we've discussed in terms of a hamburger. The effects of this war in the Ukraine on a simple hamburger, because it relates to something that we all understand. Now, obviously an effect on a hamburger for the Russian people is there's going to be 850 McDonald stores in Russia that have just closed their doors, which is $US2 billion less profit for the golden arches but from your point of view, with all of these sanctions and what's happening, what are the effects on a hamburger?

Steve: Yes, so before we get into the disaggregation of the hamburger, the two things that obviously jump to mind are the economist big Mac index, right. Which is a purchasing power index across countries. Well, Russian hamburgers have become really expensive, right, so that's the first thing. The ability of the Russian people to purchase things in the world market is aggressively impaired as a result of this. The second thing is when we think of a hamburger, we think McDonald's, as you mentioned, McDonald's is withdrawn. There was a famous advertisement just after the fall of the Berlin wall. I think with Gorbachev pizza hut, you can see this on YouTube and there was a great hope, as I said before, of Russia's integration into the world economy, which would mean a flow of foreign IP and foreign investment to Russia.

Unfortunately, this has killed that and I'm very skeptical as to whether that will ever come back. The chance that McDonald's will operate in Russia in the years ahead is I think very limited. The last thing to mention, which is with McDonald's, there's this saying that no two countries with the McDonald's have ever gone to war well, for a start, that's not true, but the fact that McDonald's has withdrawn from Russia now put some value into that, right? If two countries with McDonald's go to war, McDonald's will withdraw from at least one of them. Now in terms of the actual hamburger, well, we've seen commodity prices skyrocket, right? Ukraine and Russia export a huge proportion of the world's wheat and other commodities so that will obviously have big effects on world food production, as well as fertilizer.

Friends that I talk to who study this carefully say that that will have big effects on some countries like Yemen, right? Low income countries that directly buy a lot of agricultural products from these countries will be heavily impaired, but the global food system won't be so impaired so of that gives me some hope. The other thing is you have to remember that the hamburger, even if we put aside the raw materials, actually in the hamburger, things like wheat, what a hamburger needs to be made is energy, right? Whether it be the gas that is fired to cook the Patty, or whether it be the petrol that goes into the truck that transports the food around the world and around the country and there is no doubt that the crisis is going to put very significant pressure on energy prices, which will increase the cost of everything, right? Those inflationary pressures don't just come through petrol, they come through the price of everything. At a time, again, as we said before, at a time where inflationary pressures are high, the last thing we want is more inflation so we're going to see higher interest rates than we would otherwise have seen and lower activity than we otherwise would've seen. Unfortunately, there's nothing we can do about that. That's how I think of the hamburger,

Ross MacDowell: Stephen, fantastic. What a great summation, thank you so much for joining us on the Burgernomics podcast. You've brought a completely different viewpoint to a war because we are trained to think about rifles, soldiers, warship, fighters, fighting wars, and now it's economists fighting wars. Hopefully this elevates people's appreciation for how economics can solve issues without bloodshed and try and maintain standards of living for people around the world, rather other than countries fighting one another. Thank you very much for joining us and I look forward to talking with you again on other topics, if that's okay with you.

Steve: Sounds good Ross, let me just say one addendum because we really needed three hours for this, but I'll just say one more thing, which is as you have, I've been watching the news in Ukraine, in horror the human impact of war is unspeakable. In our conversation today, we've been somewhat light because we've been talking about economics, but the human cost of military action is tremendous. The human cost of economic action is tremendous. We're in a world where we are having to choose between terrible options, right, and we've chosen this economic path because we hope it's better than the alternative, which is shooting down Russian aircraft and launching World War III but we are in a world of imperfect, right? Unfortunately the world would've been much better if this never happened, but the best we can do is find the least cost path out of it and I think that's the angle that an economist can bring to the conversation.

Ross MacDowell: Economists as peacemakers, Ilike that. Thanks, Steven.

Steve: Cheers.

Ross MacDowell: My thanks to today's fascinating guest associate professor Steven Hamilton from the George Washington University. Please rate and subscribe to the Burgernomics Podcast on your favourite podcast channel and follow the Burgernomics Podcast on Twitter, Instagram, and LinkedIn, and join our mailing list on the Burgernomics Podcast website so you know our upcoming topics and guests.

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