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Economist View: No pain, no gain in Ukraine crisis

Without playing down the seriousness in human terms of the ongoing situation in Ukraine, it is important to look at the economic implications, and game theory provides insights.

For investors, the situation was worrying initially because the fear of the conflict widening led to a sell-off of risky assets. Then, as soon as it looked like the crisis would not escalate, the markets calmed down and investors returned their focus to US economic data or the European Central Bank press conference. This is just as well for economists, who should be cautious about taking a view on the likely outcome of a volatile geopolitical situation.

Game theory attempts to model decision-making in a situation, and considers potential actions for each player in reaction to what the other players do. Applying this theory to Russia and Ukraine, one argument is that the US and Europe should not react to Russia’s actions because the economic cost to the US and Europe is so low. While this strategy might make sense in a single, isolated game, a more appropriate strategy would be to make the outcome painful for Russia, to discourage repetition. The potential reaction that is most discussed is to impose economic sanctions.

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Sanctions are most likely to succeed when they are painful for the target country but not so painful for the countries imposing them. Many political analysts have speculated about the relative economic links between Russia and other economies, but just as economists should be cautious about taking views on geopolitical situations, political analysts should be cautious about making use of economic data. It is easy to get over-excited about a number because it sounds big. For example, commentators might note that Italy has strong trade links with Russia because it has an €8bn trade deficit with Russia. This may sound like a big number, but in the context of Italy’s GDP of €1.5trn it is small – just half of 1 per cent of GDP. In any case, if we are interested in the importance of trade linkages, it is the gross exports and imports that matter, not the net number.

At their most extreme, sanctions will limit trade and affect banks that are exposed through cross-country loans. In the case of Russia, energy linkages are important, not least because it is hard to substitute energy imports from one source with other sources. This is particularly true for natural gas, which requires pipelines for transport.

Some economic linkages can be difficult to interpret. Consider Russian investments into the European Union. If sanctions are imposed on Russia, this source of external financing will disappear, potentially leaving a shortage of funding for Europe. But from the Russian perspective, these sanctions would be painful because their assets may be frozen. Economic trades bring benefits to both sides, so ending them will always have negative effects in both directions.

If extensive sanctions were put in place, they would be painful both for Russia and the countries imposing the sanctions. But as important as any one country may be to the rest of the world, the rest of the world will always be more important to that country. The question, then, is how much each country is willing to tolerate the pain.