The Ukraine Trap: U.S., Russia, Germany and China Play Geopolitical Musical Chairs

The 18th Century called: It wants its Eastern European diplomacy back. While the world focused on a potential crisis that could have arisen from a disaster at the Sochi Olympics (which never happened), the Crimean/Ukranian crisis came as a Black Sea surprise that hardly anyone saw coming. But developments there could create globally important economic ramifications for years to come.

The Russians have dominated Ukraine and the Crimean peninsula (part of Ukraine) for hundreds of years. And although Ukraine has been its own country for much of that time, its governments have been almost always directly controlled by, or subordinated to, Russia. The control has been so complete that in the 19th Century Russia was happy to locate its primary naval base on the Crimean peninsula, a move that gave the Russians an all-year window to the Mediterranean and beyond. But in March, when a popular uprising deposed Russia's puppet government in Ukraine, Vladimir Putin lost no time shoring up his strategic interests. His moves have drawn parallels to the "Sudetenland Crisis" manufactured by the Nazis in Czechoslovakia in 1938. In that episode, Hitler exploited the supposed "oppression" of ethnic Germans living in Czechoslovakia to fracture Western alliances and win territorial expansion for his own country. And we all know how that worked out...

What's at Stake

As the Ukrainian crisis deepens (as more violent pro-Russians increasingly attack strategic targets throughout eastern Ukraine), Russia and the Unites States/EU/ NATO will likely settle into a protracted political standoff. Unlike the late 1930's, however, there is very little chance that it will lead to a continental land war fought with live ammunition. Instead, economic weaponry could be heavily deployed.

At issue is the ability of tens of millions of Eastern Europeans, particularly in the nations that formerly fell behind the Cold War's "Iron Curtain", to drift into the Western sphere of influence. However, this very old conflict does contain some distinctly 21st Century features.

The standoff could become a test of strength between the heavily indebted, but financially dominant, developed economies and the resources rich creditor nations of the emerging markets. Instead of mounted Cossacks or Katyusha rockets, the Russians now wield pipelines and refineries.

While it is clear that the West easily out-muscles Russia in financial firepower, Vladimir Putin has the advantage of singularity of purpose and the patience to play the long game. In contrast, the Western alliance is a hodgepodge of competing interests held together by loose legal and political ties. When looked at closely, various fractures emerge within the alliance that will make common purpose difficult. Putin's trump card is Europe's varying degree of reliance on Russian energy.

By seeking to "drive a wedge" between EU members or between the United States and the rest of NATO, Putin may feel confident in his ability to achieve his aims, despite his relatively weak hand. While many in the West dismiss such a possibility as paranoia, the potential for this outcome could make a profound impact on the global economy and, in particular, the energy sector.

While the EU likes to pretend that it is a united economic bloc, in practice the 27 member nations are driven by competing histories, ethnicities, ideologies, and economic necessities.

Nowhere is this variety seen more clearly than in energy policy. Nations such as the UK get little to nothing from Russia. On the other end of the spectrum, countries like Poland, Finland, Romania and Hungary get nearly 100% of their oil and natural gas from Russia. Germany sits somewhere in the middle, receiving 37% of its natural gas imports from Russia. For now, at least, Angela Merkel has stood strong against Russia, calling a nullification of the annexation of Crimea to Russia, a withdrawal of Russian troops from the peninsula, and a relaxation of Russian military posturing along its border with eastern Ukraine. But none of these outcomes seem likely without the threat of serious economic warfare.

Europe is Ill-Prepared for an Energy Crisis

But it is difficult to imagine that the EU countries of Eastern Europe, which are poorer, less self-sufficient, and less able to tap other sources of energy, would be eager to sign up for tough stance against Russia. In the past, Putin has not hesitated to restrict energy deliveries to those neighboring countries that have defied his will. In 2009, Putin literally turned the heat off while Ukraine suffered through a particularly chilly winter. Countries from the Baltic to the Balkins (many of which are unhealthily dependent on Russian energy) will logically fear similar treatment if push comes to shove. Adding to the anxiety is the fact that the vast majority of Russian gas destined for Central and Western Europe is delivered through pipelines that pass through Ukraine. This means that no deliveries can be considered secure if Ukrainian needs become desperate.

If orders from the Kremlin were to stop, or severely curtail oil and gas shipments, could there be any doubt that a Continent-wide crisis would ensue? As the leading exporter of goods in Europe, German policy seems to be largely focused on the maintenance of open markets throughout the continent. Many argue that the entire Eurozone apparatus has been constructed simply to ensure markets for German manufacturers. Nothing would cut orders faster than an energy crisis. And while many Western politicians have noted the dangers of over-dependence on Russia, the EU has developed energy policies that have only made things worse.

For the last decade or so, environmental concerns have come to dominate the energy discussion.

And while Europe has made huge strides on that front (25% of German electricity now comes from renewable sources), the era of full reliance on renewable energy sources remains in the distant future. But the environmental issue has ironically pushed Europe further into Russia's bear hug. Because of the environmental lobby, European energy producers have not been adopting the hydro-fracking technologies that have transformed oil and gas production in the United States. Similarly, the use of coal, which is relatively abundant in Europe and had provided the bulk of the Continent's thermal needs in the not too distant past, has been cut drastically.

Additionally, the Fukushima disaster has greatly discouraged European leaders from expanding their well-established nuclear power capacity. As a result, to meet the power and heating needs of the more than half a billion people in the Eurozone, there seems to be little alternative to the relatively cheap, clean and pipeline-delivered supplies of Russian natural gas.

But current events now show the risks that this dependence creates.

Recently, German Economic Minister Sigmar Gabriel seemed to state the obvious by saying that there is "no sensible alternative" to Russian gas. Given the financial realities, there should be little doubt that he was speaking the truth. Currently, Germans pay three times as much for electricity as do Americans. As a result, few politicians see much room for maneuver on any policy that further restricts supply and pushes energy prices higher. Higher prices would be even a harder pill to swallow for those Eastern European countries that are still struggling to hit their strides economically.

America Has Other Concerns

But with no dependence on Russian energy, the U.S. has an entirely different set of priorities.

In fact, an energy crisis in Europe would not push up gas prices in the U.S. (natural gas markets are regional not global). In addition, U.S. manufacturers would gain a competitive advantage against European rivals that would be struggling with higher energy costs. The price that could be paid by America in forcing a confrontation with Putin will not come in the form of higher energy bills, but in lost global prestige.

Due to a string of foreign policy blunders, President Obama is keenly aware that America is losing its reputation as the guarantor of global security. In particular, the President's failure to take action against Syria's Assad regime when it became clear that it had used chemical weapons showed weakness in the face of Russian opposition. As a result, the President does not want to be similarly rolled over by the nation that we apparently defeated in the Cold War. In order to restore this tough guy reputation, Obama may overplay his hand and be tempted to write a check that must be paid for by the Europeans. If this were to happen, Putin could be provided with a means to exploit these divisions and strike back hard on his Cold War adversary.

The Trap

In exchange for promises to contain his expansion into the Ukraine and the former Warsaw Pact countries (thereby soothing fears in Berlin, Prague, and Warsaw), Russia could look to formalize an energy trade agreement in currencies other than the U.S. dollar, the euro in particular. Such a move would help push the global economy into the "post-dollar" world that has long been mentioned by Russia and China. It would also burnish the reputation and stability of the euro, which has come back strongly from the drubbing the currency took as a result of the European sovereign debt crisis. Such a deal that marginalizes the United States would be a crowning achievement of the Putin regime. In April, Platt's Energy, a leading journal of the energy industry, reported Andrei Kostin, the president of VTB, Russia's biggest state-run bank, as saying, "It is time to change the entire international financial system that considers the dollar the key reserve currency." Kostin was reported to be in talks with major Russian energy providers such as Gazprom and Rosneft whose eagerness to make a change has been catalyzed by the Ukrainian conflict. Alexander Dyukov, the head of Gazprom's trading arm, said that 95% of his customers were ready to switch their dollar-based contracts into euros.

The fulcrum for any potential shift in the status quo may be found in Germany. In the 70 years since its defeat in the Second World War, Germany has been largely content to function as a loyal soldier in the Anglo-American led Western alliance. But in recent years, Germany (a creditor nation) has often found herself isolated from her debtor nation allies on questions of central bank and fiscal stimulus. As a result, it is not too difficult to foresee a situation where Germany becomes less willing to go along with NATO on energy and financial policy. A May 2 front page story in the Wall Street Journal detailed a series of unusually frank public comments from leading German industrialists urging Chancellor Merkel to refrain from imposing additional sanctions on Russia. This comes just two days after the WSJ reported that in late April Vladimir Putin attended a birthday celebration in St. Petersburg for former German Chancellor Gerhard Schroeder. It appears that the two remain on friendly terms.

A recent poll of Germans revealed that more (49%) wanted their country to mediate between the U.S. and Russia over the Ukraine, rather than simply back up American policy (45%). The same poll showed that a majority of Germans objected to the regular presence of NATO troops in countries that border Russia. Pushing back against the Americans on this issue could provide Germany the European leadership role that she has been pursuing since Bismarck.

The Eastern Option

But even if the EU were to resist the enticement of energy trading in their own currency, and instead were prepared to hang tough in order to teach a lesson to the bully in the Kremlin, there is reason to believe that Russia would simply look for new customers, particularly in China. By failing to criticize Russian actions in the Ukraine (China has said very little on the crisis and was recently absent at the UN vote in which the secession referendum in Crimea was declared illegal), China may be setting itself up as the beneficiary of a disruption of Russian-European gas deliveries. Bilateral trade between Russia and China has taken off in recent years, and the two countries have been cooperating diplomatically on a number of fronts. In February alone, China imported 2.72 million metric tons of Russian crude oil, a monthly pace that has more than tripled in a decade. Customs data indicates that China imports approximately 12% of its crude from Russia.

There can be little doubt that as China's energy needs explode, the country will be forced to reduce its overdependence on coal (70% of its energy supply), which is creating unsustainable environmental stress on China's citizens. Pollutants pouring from coal-burning power plants are turning many of China's biggest cities into unlivable smog pits. This will have to change. According to an April 14 Bloomberg article, the Ukraine crisis increases the chances Putin will sign a long negotiated 30-year deal to supply pipeline gas to China.

Major pipeline construction has already begun that will allow Russia to pipe gas to China that it currently sends to Europe. As the capstone of increased energy trade, Russia and China could agree to a deal to trade energy in the Chinese RMB. Such a move would shift much of the globe's economic gravity further into China's orbit, and would help the RMB take a step forward to global reserve status. As would be the case in a euro-based energy trade deal, this scenario would be detrimental to the U.S..

In any event, the crisis now unfolding contains many more seeds for bad outcomes than the financial commentators understand. If the Obama Administration falls into a trap and misplays the situation, it could see stronger ties between the Russian Federation and EU or Russia and China. Either way, it moves us closer to the "post-dollar" world that many have predicted.

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