Russian sanctions are a big deal for Europe

In the context of ample global liquidity, nothing seems to faze the international financial markets. Tuesday’s announcement by the Europeans of major economic sanctions on Russia was no exception. For despite the serious adverse implications that these sanctions might have for the fragile European economic recovery, global and European markets were barely impacted by that announcement and they continued to trade at very lofty levels.

{mosads}Notwithstanding the financial market’s seeming indifference to the new sanctions, the European and U.S. escalation of sanctions on Russia’s financial, energy and defense sectors would seem to be highly significant for the European economic outlook for a number of reasons. First, these sanctions underline that relations between the West and Russia have now plumbed new post-1989 lows. They would also seem to indicate that both the U.S. and the Europeans now expect a prolonged period of Russian intransigence towards Ukraine, especially given the strong domestic support that Russian President Vladimir Putin enjoys for his Ukrainian policy. Second, these sanctions have to raise the real possibility that the Russians will both retaliate with sanctions of their own and withhold natural gas supplies to Europe. That in turn could result in a further downward spiral in relations between Russian and the West. Third, these sanctions come at a time when the European economic recovery already shows signs of stalling and at a time when Europe faces the risk of slipping into outright deflation.

While it is true that for most European countries, trade with Russia represents but a small part of their overall international trade, souring relations with Russia could have a major impact on the European economy for a variety of reasons. First, since Russia still supplies Europe with around one-third of its energy needs, there has to be the risk that at some stage Russia uses its energy lever, particularly with the approach of the European winter. Second, the Russian economy is very much more integrated into the global financial system than was Iran, which has to raise the risk that there could be an untoward fallout on European banks from any major disruption to the Russian economy. Third, European business and consumer confidence, which has already been impacted by heightened geopolitical uncertainty, could take a decided turn for the worse if it became clear that we indeed were in for a prolonged period of poor relations between Russia and Europe.

Sadly, for the European economy, it would seem unlikely that there will be any early thawing in relations between Russia and the West anytime soon. In part, this is because for domestic political reasons it suits Putin to keep the Ukrainian crisis on a slow boil. In part, it is also because Russia presently has very large international reserves, which puts Russia in a good position to weather the recently imposed sanctions for a considerable period of time without risking plunging the economy into a deep crisis.

While the markets might be turning a blind eye to the very real risks that the escalation in Russian sanctions pose to the European economic recovery, one has to hope that the same is not true of the European Central Bank (ECB). Since in the context of the very high debt levels in the European economic periphery, Europe can ill-afford to now slide back into economic recession and to experience outright deflation. Hopefully, these considerations will prompt the ECB to move sooner rather than later toward the adoption of quantitative easing.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.