Russia’s War Is the End of Magical Thinking
In her co-authored 2018 book Political Risk, former U.S. Secretary of State Condoleezza Rice tells the story of an hourlong negotiation with Russian President Vladimir Putin. For what were clearly protectionist reasons, Russia had banned U.S. pork products. To justify the ban, Putin claimed American pork posed an unacceptable risk of the parasitic disease trichinosis because Russians tended to cook their pork less. “You wouldn’t believe it,” Rice recalled. “We spent an hour, an entire hour, on pork. … And we had this long discussion of cooking habits in Russia compared to Alabama, where I’m from.”
In the three decades since the end of the Cold War, the world was mostly stable enough to allow leaders to concentrate on pursuing and preserving economic opportunities—not only for pork producers but for all kinds of companies, small and large. The U.S.-Japan trade disputes of the early 1990s, which were mostly about Japan’s reluctance to buy more U.S.-made cars, beef, rice, and semiconductors, were a top priority for U.S. President Bill Clinton. So was the conclusion of the North American Free Trade Agreement with Mexico and Canada, which was driven largely by corporations seeking lower wage costs. For decades, Berlin encouraged German companies to look the other way at Russia’s increasingly aggressive actions in Chechnya, Georgia, Ukraine, and elsewhere; Germany is now Russia’s largest trading partner after China. World leaders made the annual trek to Davos, Switzerland, for the World Economic Forum to discuss the future of a global economy that was highly integrated and seemed to be getting more so each year. Efficiency and seamless trade were top of mind for the world’s government and corporate decision-makers.
Russia’s brutal invasion of Ukraine five weeks ago, and the punishing Western economic sanctions that have followed, did not on its own smash this complacency. The U.S.-China trade war launched by former U.S. President Donald Trump had already caused some companies to rediscover geopolitical risk and reconsider their exposure in China. The business lockdowns and travel restrictions triggered by the COVID-19 pandemic left companies around the world scrambling to find reliable suppliers. Right now, more disruptions of the global economy look likely as Shanghai and other parts of China lock down yet again to control the virus.
But the losses triggered by the war in Ukraine—and the speed at which they’ve been incurred—are unprecedented. The British energy giant BP, the biggest foreign investor in Russia, is taking a $25 billion write-down and losing a third of its oil and gas production after divesting its share in the Russian oil company Rosneft. European aircraft leasing companies could lose up to $5 billion worth of aircraft trapped in Russia by sanctions. The French automaker Renault has lost 30 percent of its market value as it unwinds its Russia-based production. Nearly 400 large foreign companies have pulled out of Russia entirely or suspended their operations, compared with fewer than 40 continuing business as usual.
The result is shaping up to be a great risk recalculation. After decades in which issues such as pork protectionism could be deemed a problem serious enough to engage a U.S. secretary of state, the possibility of truly catastrophic economic losses suddenly looms large. Were China, for example, to attempt an invasion of Taiwan, the costs would dwarf those faced by companies over Russia’s war in Ukraine. Investors are paying attention. Already, foreign owners of Chinese stocks and bonds are fleeing the market; the Institute of International Finance (IIF) has described this divestment as “unprecedented” in scale and intensity, far exceeding outflows from other emerging markets. While the institute’s chief economist, Robin Brooks, cautioned that it was too soon to draw definitive conclusions, he and others wrote in a recent IIF report that “the timing of outflows—which built after Russia’s invasion of Ukraine—suggests foreign investors may be looking at China in a new light.”
What are the implications of companies and investors massively recalculating risk? Recent research from U.S. Federal Reserve and other economists suggests there will be both short- and long-term costs. Looking back over a century, economists Dario Caldara and Matteo Iacoviello conclude that big geopolitical risk events such as wars and terrorist attacks usually result in economic slowdowns, lower stock market returns, and flows of capital away from emerging markets toward advanced economies perceived as more stable. Research from Vivek Astvansh and his colleagues suggests more lasting consequences as well. Using data going back to 1985, they find that rising geopolitical risk slows innovation as companies find the future more uncertain and become wary of spending funds on promising new technologies. These negative effects can linger for years even if the disruptions pass.
Such a recalculation of risk will be costly—but it was long overdue. Way back in 2005, when the cheerleaders of modern globalization were still full-throated, Barry Lynn—now executive director at the Open Markets Institute—warned that “corporations have built the most efficient system of production the world has ever seen, perfectly calibrated to a world in which nothing bad ever happens.” The global economy, he argued presciently, was enormously vulnerable to disruptions of all sorts, from wars and terrorism to earthquakes and pandemics. In search of efficiencies, multinational companies had blithely ignored such risks for decades.
If governments and companies learn the proper lessons, their responses could be beneficial, even if they come at high initial cost. Companies will shorten their supply chains and emphasize resilience, not just efficiency. Democratic and free-market-minded governments, such as those in the United States and much of Europe, are reassessing their dependence on authoritarian states for critical technologies and commodities. The U.S. government began this effort in a serious way in 2019, when the Trump administration ordered U.S. companies to stop using telecommunications infrastructure from the Chinese technology company Huawei and pressed its allies to do the same. Germany and other European nations face a longer road in weaning themselves off Russian oil and gas but are moving quickly to find new suppliers.
The danger is that governments and companies will overcorrect by exaggerating the new risks in the same way they previously ignored them. Looming threats, in particular, could be even more disruptive than actual events, such as wars. Facing massive uncertainty, companies and investors pull back, whereas following an adverse event, they become more confident at pricing in such risk. As deep as the economic disruptions from Russia’s war look right now, companies can adjust once the sanctions regime is clear and policies to replace Russian energy are in place. But the mere fear over an intensified confrontation with China could lead to a generalized, disastrous stampede. It is easy to go from underestimating political risk to fearing it too much. Such an overcorrection could, for example, discourage Western companies from expanding in developing countries, where they are urgently needed to prevent economic contractions, help develop economies, and provide an alternative to China’s strategic Belt and Road Initiative.
It is hard to imagine the day when a U.S. secretary of state will again spend an hour with Russia’s president talking about pork. Nor should we hope for it. The geopolitical stability of the past three decades produced too much magical thinking by governments and companies alike. The global economy is still highly integrated—but also prone to great disruptions. A sober calculation of risks and rewards is just what is needed now.
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