Matthew Klein on the Economic Fallout from the Russia-Ukraine War

Matthew Klein is the author of The Overshoot, a newsletter that helps readers make sense of the global economy. Matthew also closely follows Eastern Europe and Russia, has written on the economics of the Russian-Ukraine War, and is a returning guest to the podcast. Matthew rejoins David on Macro Musings to discuss this conflict and its broader economic implications. Specifically, Matthew and David discuss the historical context dating back to the Soviet Union and leading up to this conflict, how Russia’s economy has been historically linked to Ukraine’s, the consequences of Europe’s reliance on Russian fossil fuel exports, and the implications of global sanctions against Russia for dollar dominance, globalization, and inflation.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Matthew, welcome back to the show.

Matthew Klein: David, thank you very much for having me.

Beckworth: Wasn't too long ago you were on here. It was late November and we were discussing inflation. And today we're going to talk about another big story that also has a bearing on inflation and maybe we'll come back to that angle, but we'll save that for the end. But we're going to talk about the Russia-Ukraine war. Everyone's talking about it, but you have a unique skillset. You're both an economist, you've written, you're a journalist, but you also have a background in Russian history. So I think you're ideally suited for this and I imagine the demand for your services are up during this period. So thank you for taking time out to join us.

Klein: Thank you for having me.

Beckworth: Yeah, it's great to have you on. And for listeners, just to be clear, we are recording this on Wednesday, March the second, and this show will come out on Monday, March 7th. So a lot could happen between now and then, but hopefully this will still be timely and we're going to talk about some history, the broader context, and that should be something that's important even by Monday.

Beckworth: Okay. So Matt, let's begin and let me just start by saying, wow, we're in day seven of this conflict and it seems like there's some pretty big historical sea changes taking place in the global order. And maybe some of these will fade, but it does seem like there's been some big, big changes taking place as a result of this conflict economically, politically, and I want to get into them with you. A lot of changes in Europe, potentially a lot of changes in military spending, alliances and such. So let's get our conversation first started by looking at the historical context of this conflict. So I mentioned earlier, you're a bit of a historian of Russia. So maybe walk us through that. What is the historical context here behind this conflict?

Historical Context

Klein: Well, I’m a little bit of a historian of Russia. I took a few classes in college and wrote a thesis on it. Well, we could do a whole lot of context here. I mean, you had the breakup of the Soviet Union in 1991 into its constituent states, Russia and Ukraine being the two most populous ones. And at the time that happened, a lot of the USSR's nuclear arsenal was in what became Ukraine and there was debate on what to do about that. There ended up being a treaty that was negotiated between the US, the UK, Ukraine and Russia, that Ukraine's territory integrity would be guaranteed by the four powers, or the three powers in Ukraine, and in exchange, Ukraine would voluntarily give up its nuclear arsenal.

Klein: In retrospect, I think that was a good deal in so far as having nuclear proliferation I think is not great for global security, but obviously there wasn't a lot of follow-through given what's happened in the past eight years. Ukraine had a very poor time coming out of the end of the Cold War, much more so than Russia, unlike a lot of the other post-Soviet states. So you have the Baltics, Latvia, Lithuania and Estonia. They actually did very well. They made an extraordinary effort to join Europe in every possible sense and achieved a remarkable degree of economic convergence. They're also both very small and they were able to do that.

Klein: You have a lot of central Asian states that had natural resources that they can export, Kazakhstan, Turkmenistan, Uzbekistan, Kyrgyzstan, they did okay, not great. I mean, they were never particularly prosperous, but in a period of the long, secular commodity boom, being able to export natural gas and other commodities worked out okay for them. Then you have Russia and Ukraine and Belarus, and there you have a problem where the manufacturing side of the Soviet economy was not very efficient with the notable exception of military hardware. That's still something where Russia has a comparative advantage, if we're going to use the technical term. That was something that overall was very good at, but otherwise for making most other things, not particularly good. The service sector was not very good, but Russia proper did have immense resources in terms of oil and gas and various metals and gold, and that ended up basically sort of offsetting the weakness they had in everything else.

Klein: Ukraine and Belarus did not have those advantages in terms of natural resources, but they did have all the disadvantages of the manufacturing. And so they were really sort of [inaudible], like the backwaters and they did not have very good transitions. They didn't have the political transition that you had in the Baltics or in central Eastern European states that went through, people call it shock therapy, which I think has a lot of bad connotations. I think oftentimes the way it was implemented did not necessarily go as well as it could have, most obviously in Russia proper, but in central Eastern Europe, you did have this really wholesale transformation of institutions that worked out pretty well taking sort of long view.

Klein: I mean, you look at where Czechia and Slovakia for example are right now. I mean, they basically made it. People talk about conversions as being sort of an east Asian only story. That's not quite true. Central Eastern Europe basically did it. They pulled it off. They had help to be sure from Western Europe, but they did pull it off. You didn't really see that in Ukraine at all. They had tremendous downturn in the nineties, just like you saw in Russia, but then you didn't really have any kind of later boom because there wasn't the gains to be had from rising oil and gas prices.

In central Eastern Europe, you did have this really wholesale transformation of institutions that worked out pretty well taking sort of long view...you didn't really see that in Ukraine at all. They had tremendous downturn in the nineties, just like you saw in Russia, but then you didn't really have any kind of later boom because there wasn't the gains to be had from rising oil and gas prices.

Klein: There was a lot of corruption, a lot of the sort of problems that we are familiar with sort of the other post-Soviet countries. You get to the global financial crisis and this is something that Adam Tooze wrote about, I think did a good job explaining this, how the global financial crisis really ended up hitting Ukraine. It hit a lot of central Eastern Europe, but it hit Ukraine pretty hard. And you get to the period of sort of around 2013 or so. And essentially there's a potential deal from the European Union, not to join the EU, but for sort of a greater economic partnership. At the same time, Russia is offering Ukraine its own deal.

Klein: In financial terms, the EU deal was actually a lot worse, which is very consistent with the behavior of the EU and that particular point in time being very stingy and penny pinching. But nevertheless, despite that, it ends up being the case that the Ukrainian populace, or at least much of the Ukrainian populace, would prefer to associate with Europe anyway, compared to the alternative because the idea was that these are sort of mutually exclusive. You have to pick one. Being in the middle wasn't really an option. And they ended up going.

Klein: There were protests in the street and there was the Maidan, you call it revolution or protest or what have you. The Russians call it a coup, which I don't think is really accurate description of what happened, but there was a change in government policy. And then Russia basically said, this is unacceptable and they attacked. They invaded. They basically sort of hived off, not completely, but effectively sort of the Eastern strip of Ukraine and the annex Crimea, which Crimea had long been hosting a Russian Naval base there. So they didn't really have to fight very hard because their soldiers were already there, but they took it, annexed it. It's an annexation that most of the world has not recognized officially.

Klein: And then you have the past eight years of this sort of weird stalemate situation where Russians claim that there are no Russian regular forces in Ukraine, but they're people who are not Russian regular forces who are fighting for the liberation of this area called the Donbas, this far Eastern part of the country worth knowing that Ukraine like much of the world, much of what Eastern Europe was like before World War II anyway. It's not perfectly, ethnically, linguistically homogeneous within borders. You have a lot of different groups of people. So there's plenty of people who are native Russian speakers inside Ukraine. Generally, they're in the Eastern part of the country, but it's not exclusively that way. But one thing we've seen recently is people don't define themselves purely by that distinction. But the Russian government used that as an excuse for saying that Russia should control the part that the Russian speakers live.

Klein: So you have that going on for a while. I believe it was in 2019, you have an election in Ukraine and a new reformist government comes in and that's how Zelenskyy becomes President. He basically ran, as we've seen in some other countries, on “I'm an outsider, I'm clean. These other people are all corrupt.” And people responded to that and he ended up winning this landslide election victory and tried to improve the situation as best he could.

Klein: After the first Russian invasion in 2014, Ukraine sort of by default ended up moving more economically towards Europe. They didn't really do any big deals or anything, but their trade relationship shifted somewhat to being more towards Europe. The Russian government ended up changing its relationship with Ukraine, sort of punished them for that most notably in the way that they root natural gas through Ukraine to the rest of Europe. They basically cut back on that because that was an important source of revenue for the Ukrainian government. And then what exactly happened to prompt the specific attack now? I mean, I guess, the intelligence community was not surprised.

Beckworth: They called it.

Klein: It’s actually really striking where people were like, this can't be, but of course, the reason why they said this can't be, which I think is really interesting is that there was this sort of underlying assumption of, they wouldn't be that stupid. They wouldn't be that reckless. They wouldn't be that destructive. They have a good thing going. Why would they do that? As opposed to, your sort of rational brain is coming in and ignoring all the facts. All the evidence is like, yes, they're clearly planning to invade. You wouldn't put all these soldiers there. You wouldn't amass on the border. You wouldn't have all these deployments along in Belarus, which is basically de facto Russian client state here and also shares a border with Ukraine. You wouldn't have moved in the blood banks. I mean, it's very consistent when they were going to attack, but then no one's like that truly they wouldn't.

Klein: And in fact, now we're seeing why it was probably not a smart choice to have done that and that's essentially what happened. Putin gave this whole long speech basically saying he wanted to reconstitute the Russian Empire and that it was a mistake to breaking these things off and Ukraine doesn't deserve to exist as a real country and a lot of stuff. I mean, there's some speculation about him being very isolated because of COVID and maybe not getting good information. Not going to pretend to be able to give you any deep insight on that, but that's essentially what brought us to where we are and in terms of the politics of it. I guess, you probably want to know more about sort of the economic background.

After the first Russian invasion in 2014, Ukraine sort of by default ended up moving more economically towards Europe. They didn't really do any big deals or anything, but their trade relationship shifted somewhat to being more towards Europe. The Russian government ended up changing its relationship with Ukraine, sort of punished them for that most notably in the way that they root natural gas through Ukraine to the rest of Europe. They basically cut back on that because that was an important source of revenue for the Ukrainian government.

Beckworth: Well, before we get to that, it's very interesting and you're right. Had they known before the invasion what the measures would've been taken by the EU, the US or rest the world, they clearly would've been rational like we thought they would be and probably had said no, but they did and they went ahead. I want to spend a little bit of time on Putin. He's been in power now for over 20 years.

Beckworth: Early on, there was some hope he was going to be a modern reformer, but he slowly has moved away from that to where he is to this point today. 2018 he invaded Georgia as well, and then 2014, as you mentioned, parts of Ukraine, and now this all out invasion of Ukraine. I guess, I want to bring this up in a broader context. This is not about NATO, right? Some people are talking about, oh, this is all because of NATO pushing the borders. This is a longer story. Maybe it has partly to do with him and his personality. He's getting older, but maybe it's this deep seated desire to bring Ukraine back into the fold. So how do you respond to that observation, this is about NATO?

Klein: Yeah. Well, the second part's a complex question, but is it about NATO? I would say the answer is no. I mean, in 2007, he gave that speech to the Munich Security Conference, Putin did, basically saying that it was unacceptable for NATO to be expanding too close to Russia's borders. NATO then basically just ignored that. And there was in 2008, this sort of open invitation for Georgia and Ukraine to consider joining. Then you have the war in Georgia, Ukraine then says, no, never mind. They basically pass a law saying they're not going to join any military alliance. And in fact, they very much did not join NATO.

Klein: The last time there was a NATO expansion at this point was quite a long time ago. NATO expansion that's on Russia's border, I should say, or close to Russia was quite a long time ago. I think Montenegro and north Macedonia may have joined more recently, but that's not adjacent to Russia. So there's been quite a long period of time. It was not something that the Ukrainian government had been thinking about.

Klein: Basically ever since the attack in 2014, they'd become ineligible. And I think that was actually part of the reason why Putin did it was because if you had have this sort of low level civil war/not entirely civil war because there are Russian soldiers there, not in Russian uniforms, you're not eligible to join NATO. There are rules about these things and it's very clear, you can't be in the middle of an active war zone at the time, so that was all known.

Klein: It's not as if there was this plan that Ukraine was about to join NATO at this point in time. None of that was on the cards anytime soon, if ever. I think it's really telling that the event that prompted the attack in 2014 was this debate within Ukraine that led to the change of government in Ukraine about the EU Association Agreement and the trade and the deepening economic, peaceful economic links with the EU. That was what prompted the attack in 2014. It was not about NATO.

Klein: Since then, you've had this deepening of economic links, but again, there was nothing specific that precipitated the most recent attack, except if I'm going to be cynical, I'd say Russia finally got over the fact that COVID was very destructive in Russia. They did not do a good job of handling it. They think they've sort of gotten past a degree and energy prices are now high enough that it might have made them think that they had more leverage and that might be why they did it now as well to say a year ago or two years ago. But otherwise, I mean, there's not people pointing. I'd be very, very suspicious if anyone says, oh, well, NATO added the Baltics in 2004 or whatever. That's why Russia attacks Ukraine in 2022.

Beckworth: I mean, Kaliningrad is surrounded by NATO and you have, as you mentioned, Lavia and Estonia already on the border, so it's nothing new. And I think this story you just told makes a whole lot more sense, so, interesting to see. Well, let's move to the Russian economy itself and talk about the ties to Ukraine and ultimately to the broader global economy, what it might mean for Europe and here in the US. So walk us through the Russian economy. You've already touched on some of it, but go ahead and again, what is its fundamental resource? What's driving it and how should we view it? Is it a Petro-state? Is it something else?

It's not as if there was this plan that Ukraine was about to join NATO at this point in time. None of that was on the cards anytime soon, if ever. I think it's really telling that the event that prompted the attack in 2014 was this debate within Ukraine that led to the change of government in Ukraine about the EU Association Agreement and the trade and the deepening economic, peaceful economic links with the EU. That was what prompted the attack in 2014. It was not about NATO. Since then, you've had this deepening of economic links, but again, there was nothing specific that precipitated the most recent attack.

Russian Economy and its Ties to Ukraine

Klein: I think Petro-state is fair. Although, it's not a Petro-state in the way like some of the Gulf states are. So just to break it down a little bit. Russia is 140 plus million people. It's a very large country, covers enormous land area. In terms of exports, it is mostly natural resources, although natural resources, fossil fuels are the minority right now. As of 2021, they were in the minority. It was like 40%.

Klein: So oil, natural gas, and coal were substantial, but they also have a lot of other things. Wheat is huge, a whole bunch of industrial metals, also things like palladium and gold, neon. So it's basically all the raw materials that you use, I think, I don't know if it's still the case that timber, but I mean, historically timber has been a big export. Domestically, obviously there are a lot of other things they have. They do also still have a relatively sophisticated military industrial complex. So again, I don't know exactly how you rank that in terms of export share, but I mean, it's arguably why some countries have been reluctant to criticize Russia even now. I think India's being the most obvious one, because they get a lot of their military equipment from Russia and they need to get the spare parts and maintain that relationship.

Klein: So it's not just a petrostate. They have plenty of people working in Russia from the central Asian states. The other, basically a lot of the other post-Soviet states traditionally, and especially when oil price is high, those people send back remittances. That's an important source of income for a lot of those places. That's basically been hosed. So that's a significant extent of collateral damage that's been caused by this conflict of those states not having access to remittance income.

Klein: In terms of the linkage between Russia and Europe and Russia and Ukraine, there's two big ones. One is that Russia, basically since the early 1980s, has had pipelines to take natural gas basically across the Urals. And a lot of it comes from Siberia into Western Europe. Those pipelines that go, there are three basic routes. There's the route that goes underneath the Baltic Sea directly to Germany. There's the route that goes through Belarus, to Poland, to Germany. And then there's the route that goes into Ukraine. Or there are a couple routes that go into Ukraine, and then those split off in a whole bunch of other areas.

Klein: And I'm not exactly sure when it was, but basically, unlike Belarus, where the gas transportation network is wholly owned by Russia's gas company, Gazprom, in Ukraine, once the gas hits the border with Ukraine, it transfers from Gazprom to the Ukrainian state gas company called Naftogaz, and then Naftogaz sells it on. And this is part of a dispute that Russia has had with Ukraine in terms of the payment for that. And of course they can just alter how much flows through one way to another way to sort of affect their income. Worth noting, by the way, that Russian gas deliveries to Europe since September or so of 2021 have been falling quite rapidly. So I think this may have been sort of a planned thing.

Russia, basically since the early 1980s, has had pipelines to take natural gas basically across the Urals. And a lot of it comes from Siberia into Western Europe...there are a couple routes that go into Ukraine, and then those split off in a whole bunch of other areas...in Ukraine, once the gas hits the border with Ukraine, it transfers from Gazprom to the Ukrainian state gas company called Naftogaz, and then Naftogaz sells it on. And this is part of a dispute that Russia has had with Ukraine in terms of the payment for that.

Beckworth: An intentional withdrawal.

Klein: Well, they didn't say it was unintentional. They didn't say what happened. I mean, all I know is as of, well, I haven't been able to get any updated data for a week or so, but before that-

Beckworth: It would be consistent with what they're doing now.

Klein: Yeah. I mean, before then you could see, Gazprom actually published daily gas delivery data. It was actually really high quality, useful information, if you wanted to look at this. And I wrote a piece on this that came out last week that looked at, they tell you basically which route it goes and how the deliveries were. And you can see from January 1st through August 31st of 2021, it's pretty stable at one rate, and then it starts going down pretty dramatically. And you get to the point that basically from January 1st of 2022, until basically before the invasion, because after that I stopped being able to access their website, so I don't know, but from that period of time, gas deliveries through all routes were basically 36% lower than it was in that previous time.

Klein: And in particular, the gas that was coming through overwhelmingly was coming through only by the one pipeline that went under the Baltic Sea. The gas that went through Ukraine, the gas that went to Belarus, basically more or less cut off. This is before starting the actual invasion. So I think that was arguably to put pressure on Europe and demonstrate the extent of the leverage they had. Apparently Europeans have been willing to deal with that, but we're seeing it in much higher natural gas prices.

The gas that went through Ukraine, the gas that went to Belarus, basically more or less cut off. This is before starting the actual invasion. So I think that was arguably to put pressure on Europe and demonstrate the extent of the leverage they had.

Klein: The other big economic relationship, of course, is that Europeans export a lot to Russia. Russian companies sell oil and gas and other things. And then that generates hard currency they can use to buy luxury handbags or fancy cars or industrial machinery or all sorts of other things. And I think part of the reason that Putin was willing to take the risk that he did is because in the past those business links had protected Russia from more punitive sanctions or anything else in the past.

Klein: I mean, after 2014, when they attacked Ukraine, there was pushback, but that pushback was concentrated in the US, which has of course much fewer economic links to Russia, and it was not really seriously done in Europe. And in fact, one thing I mentioned, which I found striking, is that actually Europe's total gas imports went up from Russia, not total globally, but total from Russia went up after that period. And in fact, Germany, really up until I think the beginning of this, actually, I really think it was up until even the invasion, Germany was planning on opening a second pipeline called Nord Stream 2 to go under the Baltics, that would've even further increased their dependence on Russian natural gas. That's since been canceled, or indefinitely postponed or what have you.

Klein: But up until recently, and there were stories about Putin meeting with business leaders for like the equivalents of chambers of commerce from Italy and France and Germany and countries where there were these deep relationships, in the month or so before the invasion, with the expectation that they would moderate the response. And I think if things had gone the way Putin had thought, in particular, if the military situation had gone the way he thought, which is that the Ukrainians would just roll over, Europeans would've accepted it as a fete accompli, because what would be the point if the Ukrainians weren't going to fight back?

The other big economic relationship, of course, is that Europeans export a lot to Russia. Russian companies sell oil and gas and other things. And then that generates hard currency they can use to buy luxury handbags or fancy cars or industrial machinery or all sorts of other things. And I think part of the reason that Putin was willing to take the risk that he did is because in the past those business links had protected Russia from more punitive sanctions or anything else in the past.

Klein: I mean, I think the real reason we've seen this pushback in the financial sphere and everything else is precisely because the Ukrainians have been fighting so vigorously and keeping the Russians at bay, for now anyway. We'll see how things play out, but I think that is the thing that was the really big surprise for Putin and that is the sort of underlying reason why everything else cascaded in terms of the economic response.

Beckworth: So one observation about the economy of Russia, you wrote about this in your newsletter, is how it was very conservative in government budgeting and saved up a war chest coming into this. Now we know this war chest is no longer useful, given the sanctions that have been imposed, but I was very surprised to read this. They were again loosely called a petrostate and maybe not an autocratic petrostate, but one with good public finance in terms of saving for a rainy day fund for a war. So they had their act together on that front. The other point you raised in one of your newsletters that's tied to what you just said, I want to read a quote from a recent one. You put, "Europeans can and should be blamed for becoming even more reliant on Russian fossil fuel exports since 2014 invasion of Ukraine." So expand on that.

I think the real reason we've seen this pushback in the financial sphere and everything else is precisely because the Ukrainians have been fighting so vigorously and keeping the Russians at bay, for now anyway. We'll see how things play out, but I think that is the thing that was the really big surprise for Putin and that is the sort of underlying reason why everything else cascaded in terms of the economic response.

Europe’s Reliance on Russian Fossil Fuel Exports

Klein: Yeah. So I mean, that sentence, to be clear, was right after saying they can't be blamed for the fact that Russia did all these things to fortify themselves against sanctions, but they can for their own choices. And yeah, I mean, I was struck to see this in the data, because I hadn't looked at it before. I didn't know really what the answer was, but the fact is that if you compare 2013 to 2019, which I think is the best comp we have, European fossil fuel demand went down a little bit, but Russian fossil fuel imports went up. So not only did it mean that the share of the total, so the share of total energy coming from Russia went up from like 16 and a half percent to 18 and a half percent over this period.

Klein: Now, you can argue, I think fairly, that it takes a while to adjust, but it's also true that if you'd started making the adjustment process in early 2014, we would not be in the situation we're in now, where we're worried about Europe losing access to natural gas. I mean, eight years is a significant amount of time to get things done. I mean, maybe it would've taken the full eight years, but it could have been done. And I remember, I guess I've been in this business long enough. I wrote a piece back when I was at Bloomberg in early 2014, the first time they [Russia] attacked, and I made the point pretty explicitly, longer term if the Europeans wanted to, they have the Russians over a barrel because without Europe's demand, suddenly it's going to be a lot harder for Russia to sell its gas.

Klein: I mean, yes, they could eventually build new pipelines to sell to China or something like that, but that would take a very long time, and it also would mean that Russia wouldn't have the leverage to pressure Europe if they wanted by threatening to cut the gas off. So the fact is the Europeans didn't really do anything to fix that. I mean, they built some LNG terminals and stuff, but I mean, Germany has no ability to import LNG, liquified natural gas. There are other European countries that can, but Germany cannot. They're now working to change that.

Klein: The other thing, of course, is that even though there was some investment in renewable energy, it wasn't enough to offset the fact that in particular, in Germany, you had basically the comprehensive shutdown of all nuclear power, and the way that the Germans responded to, or the way the German government responded to the loss of nuclear power, was to increase coal use. But it also meant they couldn't wean themselves off of natural gas, because if you think about where your electricity's coming from.

Klein: So these were all choices, and they could have made different choices. And it's unfortunate because you think about how the two sets of governments responded in 2014, they learned very different lessons from it. The Europeans didn't seem to learn any lesson from it, as far as I can tell. I mean, there was some military assistance to Ukraine afterwards from the US and the UK and stuff, but that's the main thing that happened, which by the way, turned out to be very significant.

In early 2014, the first time they [Russia] attacked, and I made the point pretty explicitly, longer term if the Europeans wanted to, they have the Russians over a barrel because without Europe's demand, suddenly it's going to be a lot harder for Russia to sell its gas...I mean, yes, they could eventually build new pipelines to sell to China or something like that, but that would take a very long time, and it also would mean that Russia wouldn't have the leverage to pressure Europe if they wanted by threatening to cut the gas off. So the fact is the Europeans didn't really do anything to fix that.

Klein: But then the Russians, on the other hand, they had a very comprehensive, because there were some sanctions that were put in place, and what they did was, I mean, so to be very specific, Russia generally for a very long time, ever since the 1998 crisis, has had very large current account surpluses.  It's the view that that's the way you have security. I mean, it makes sense, if you have a very, very painful balance of payments crisis, it seems to be true globally, the way you respond as either a government or society or whatever it is, you really want to make sure you don't have that happen again. And you have sort of persistent current account surpluses, and it's relatively easy to do when the oil price is high.

Klein: Interestingly, they continued that even in 2015, 2016, when the oil price was much lower, and they did that by absolutely squeezing imports and by dramatically cutting the government budget and really inflicting a lot of pain on Russian households, but they still maintained their current account surplus. And they burned through some reserves, but they still held on pretty vigorously, very conservative macroeconomically.

Klein: Incidentally, the Soviet Union was like this as well. They were very conservative macroeconomically. It goes back to Stalin, actually, this idea that you have to be, because I mean, it makes certain sense, if your overriding worldview is that everyone else in the world is out to get you, which was very much the Stalinist Soviet thinking, then you obviously don't want to be dependent on global finance for any of your needs. And so you're going to end up sort of by default running a very orthodox macro policy. And I don't think Putin and Stalin are the same, but I think that basic argument of we want to maintain our independence and we don't want to be, you know, I think it's very consistent with that.

Klein: And you combine that with the fact that for whatever reason, the Russian Central Bank actually has been run for a very long time by very competent people, and they were able to pull this off, essentially. So they have very large reserves. Of course, the thing is reserves is the claims on someone else. And if no one else in the world wants to deal with you, then it doesn't matter, that sort of thing.

Beckworth: Right, that's the irony of this, right? That's the irony, that they wanted to be self dependent, not rely on others, that Stalin mindset, but in turn, they actually relied on a very interconnected financial system that could take away that very freedom they wanted.

Klein: Right. I mean, again, it all gets back to the fact that there's no way to protect yourself from the kind of sanctions that are currently happening. There are ways to protect yourself from other kinds of sanctions or more moderate sanctions or just consumer boycotts or whatever, all those things you can do. And that's basically what they did. But at this stage, I mean the kind of unrestricted financial warfare, if you will, that's being deployed on Russia, there's nothing you can do to protect yourself against that except being fully autarkic economically and literally not needing imports, which is not-

Beckworth: Not easy at all. Well, let's talk about the sanctions. Let's move into them. Also, the other responses. So two categories of sanctions, and then we can think of some of the other responses such as countries, Germany, I'm thinking in particular, increased military spending, maybe going back to nuclear energy more. But let's start with the sanctions. Are you impressed with how quickly they scaled up, and should they go all the way and include the oil industry, which is that big source of funding for the Russian government and therefore its military operations?

Evaluating the Sanctions on Russia

Klein: Yeah. So those are good questions. I mean, the first thing is I was very impressed because I only have so much knowledge of what track record of what to go on here. And the track record I've seen in particular is A, what happened in 2014, was the most direct comparable, and then just how Europeans responded to the euro crisis or what have you, and was not super – I mean, I didn't know.

Klein: And I think to be fair, there was originally some ambivalence about how to proceed. But the fact that, as I mentioned, the Ukrainians have done and continue to do a remarkable job of standing their ground and fighting in a way that I think a lot of people were not anticipating, and it becoming increasingly clear the brutality of the Russian attack force, which again, I think they weren't expecting either. I don't even think, I mean, the sense I get and I'm sort of looking at this probably the same way as you are, so who knows, but the sense I get from what I'm seeing is that basically no one in the Russian army really knew that this is what they were getting into. You have a lot of conscripts and stuff, or they just wanted to get a paycheck. And they didn't know they were going in to be doing this kind. And I don't think they're very happy about it, quite frankly. I wouldn't blame them for not being happy about it.

Klein: But it's the fact that they're now doing more and more attacks on clearly civilian targets, just indiscriminately shelling or what have you. I think that ended up leading to a rather phenomenal development resolve. I mean, Switzerland sanctioning Russia, the fact that Sweden wants to join NATO, I mean, that's remarkable.

Beckworth: Right, right.

Klein: I mean, it was obviously slightly different circumstance in terms of their own threat of being invaded. But Switzerland was neutral in World War II. Sweden was neutral in World War II. The Bank for International Settlements rather notoriously processed Nazi, basically allowed the Nazis to steal gold from other people and then turn into hard currency throughout the war. I mean, there's this section on the BIS website. This is not what happened this time.

Klein: We've seen, as I said, basically the entire world's financial system, the only exception is China, and even China isn't saying they're going to flagrantly break the sanctions, they're just not actively participating in them, which is basically the same thing. Because there's only so many things you can get with Chinese yuan. Everything else they want to get would probably be in dollars or euros.

Klein: And if they can't use them, that's incredibly punitive. In terms of your question about sanctioning energy, I think, there's a good reason for that, which is Europeans need it. This is a short version. You could, I guess, turn on off a third of Europe's natural gas supply at once, which is essentially what would happen. But that sounds pretty severe, and that would be very challenging to manage. It's not winter anymore, so I guess they have that going for them. But I think that's the good argument. You could argue, I think, it's compelling is that the sanctions were crafted in a way so that the Russians would have to keep producing the energy, but then really wouldn't be able to do a lot with it.

Klein: Now, of course it does lead to the interesting question of why would Russia want to keep producing energy if they can't spend the revenue somewhere? And so that I think, I don't know. We haven't seen the gas problem... The gas problem's no longer putting the data in a place that I can see it anyway. So maybe they have stopped delivering gas. I don't know. Maybe that's the conclusion they've come to. But at that point though, then the onus is on the Russians. And then of course, I think, you could make the case and I've heard this argument made elsewhere and I find it plausible, which is that if the Russians cut off the gas, then it's their fault. As opposed to, if you tell them you don't want to take the gas, that's your fault.

Beckworth: Interesting.

Klein: So, I don't know if that's the case, but that would be plausible. I guess one note that I would say, as you mentioned about it, that's funding their war machine, is it's not necessarily true in so far as, these guys are paid in rubles. The bigger issue is they don't have spare parts. Right?

Beckworth: Yeah.

Klein: The fact that Boeing and Airbus said, "We're never going to help your commercial fleets fly again." Someone I saw said this on Twitter, like they're going to be paperweights basically.

Beckworth: That's a good point.

Klein: That's not on the military side but-

Beckworth: It may have funded the military prior to this war, but it's not going to be making much difference now. I'm going to go to that example of Boeing you gave. I want to tie that into the sanctions. So the sanctions, you can think of being applied to the financial architecture and then to the elites. And it, at least in my lifetime, it's amazing this scope and this scale. The EU, the US, the UK, and then some of these other countries you mentioned, Switzerland too is coming along, which is again, shocking. This pretense neutrality, they're dropping. But they're going to restrict all activity with the Central Bank, at least accessing its foreign reserves, the ministry of finance, their sovereign wealth fund, and then a number of banks as well, correspondent banks, can't work with them.

Beckworth: And then a number of private firms are kind of following suit. They see the writing on the wall. They may not be technically sanctioned themselves, but you mentioned Boeing, BP sold its share, a $25 billion hit. And yet it's going to pull out. Shell, I read recently, is doing the same thing. Apple. So a number of firms, private firms are also doing this. And this is what to me is the most amazing part of the story is this unified response.

Beckworth: And with regards to like China and Indy, the last hope that they may have, our friend Mike Bird puts his tweets out recently. And I just want to read one that he said that I think from yesterday, he goes, "The idea that Russia is sympathetic or typically neutral states would let their banks test the limits of combined US, European sanction was always pretty silly, but it's so impressive to see how quickly it has collapsed." And then he provides several stories, news clips in his tweet here. But one says, "Exclusive. India's top lender stops handling trade with sanctioned Russian entities." Next story, "China's CIPS won't rescue Russian banks from SWIFT ban." Another article, "China's Russian coal purchasers stall as buyers struggle to secure financing." And finally, "Singapore banks halt Russian commodities lending to cut risk."

Beckworth: So even the last holdouts, they're getting nervous too. And so I want to use this as a segue. We'll come back to some of these other points, but I want to use this as a segue to another point I was going to bring up later, but I think it's important, it's tied to this. And that is, one of the concerns about the use of economic sanctions that have been brought up. I've had some guests on the show. There's lots of people who've written about this, is that it could undermine the dollar's dominance. That if you abuse this tool too much, Russia and China are going to get mad and go form their own international payment system. So be careful, be sparing, don't be too liberal in applying this economic sanction.

Beckworth: But if anything, I think this experience has shown the complete opposite of that. That you can't escape the reach and the scope of the international payment system, the euro, the dollar, and if you try to fight it and everyone's on board, you're in trouble. Look, we see like yields on treasuries went down. Some of that's just purely rush to quality, but the dollar's gotten stronger. So what are your thoughts? Has this response and the fact that everyone is kind of pushing Russia into a corner financially, does that prove or suggest that the economic sanction concern was wrong? Or is it too early to tell?

Could Sanction Overuse Threaten Dollar Dominance?

Klein: Well, I wouldn't say that was even a concern. There's a line I like, don't threaten me with a good time. I mean, if the dollar's primacy could be reduced and you have less excess holding of dollar nominated assets and all the distortions that creates for the US economy, that would be a nice bonus as far as I'm concerned.

Beckworth: That's true. That's true, man. I should remember who I'm talking to here.

Klein: Right. In the book that I wrote with Michael Pettis, “Trade Wars are Class Wars.” We've talked quite a bit about this.

Beckworth: Right. That's a policy goal of yours.

Klein: Right.

Beckworth: Yeah. Putting that to the side, does the threat of economic sanction that's overused and this would be the extreme use of it, undermine the dollar's role in the world?

Klein: Well, I think, yeah. As you said, like, no. I think that the only way that would happen and if we're talking about overuse, is the kind of... This isn't really a good example of this. Because overuse would be like the US is doing something unilaterally that no one else wants to do.

Beckworth: Yeah.

Klein: But basically what we're seeing now is it's not just the US. It's the entire EU and the UK and Switzerland and Japan and Canada. And basically, you really have to be kind of an odd one to not be involved. China's not explicitly sanctioning Russia, but they're not helping either and they don't want to be caught on that line. I think Russia is sort of, I think this is what, again, something Putin was probably not expecting. They basically turned themselves into North Korea in terms of their relationship with the rest of the world.

Beckworth: Nice comparison. Yes.

Klein: You know, nuclear armed, big conventional military. They're sort of friendly with China in the sense that they're the only country that's going to be friendly to them at all, but everyone else in the world is going to cut them off. And that's not a good place to be. The reason why... So I mean, the real interesting counter factual would be like the US does something and then Europe and Switzerland, Japan ignore it, which we've not seen. And I think we wouldn't see because quite frankly, we have to just use some common sense here. The US government doesn't just randomly do things like this.

Klein: Given that the sort of unified financial front... Quite frankly, this gets back to the real economy link. There's not a lot in the world that you would want to buy that doesn't come or through either, or come from directly or come through the economic block, the currency blocks that are banning Russia right now, that are sanctioning Russia. The one exception here is China. But again, China does enough business with all the other places. Russia is large geographically. It is large in terms of its population relative to many other countries. It has a large military. It has nuclear weapons, but economically it is not enough of a player to justify maintaining that relationship at the cost of all your other economic relationships.

Klein: And so that I think is the problem that they're... It's coming quite clear. If you're a business, you might not like losing the Russian market, but compared to losing everything else, I mean the sort of self sanction that you were talking about, I don't think anyone actually said that Apple's not allowed to run Apple maps and have Apple store running in Russia. They just decided it wasn't worth the risk. And quite frankly, this is also a situation probably where Apple employees are also like, "Why would we do this?"

Klein: So those are sort of twin pressures. I think we're seeing this for a whole host of companies, that it's just, A, it's not worth the risk. There's probably some justifiable or sentimental appeal from employees and staff and stuff. It's just not worth it. The list of companies or businesses globally that they care more about their Russian business than they care about Europe and Japan, and the US, is going to be very small. And we're seeing that play out. So whether that's a reflection on the dollar per se is trickier, but in terms of the G7 writ large, I think it's-

Implications for Globalization

Beckworth: Yeah. So it's a little more complicated than just a simple binary decision. But all right, I want to use that as a segue from this talk about sanctions, and then, again, the other part of this is just been the response, the unifying response and the change in trajectory of many countries. We mentioned Germany, but Europe in general. I suspect, I think you agree, that probably increased military spending going forward in Europe. They see this danger still a clear and present threat, maybe a little spawn and interest in alternative energy sources, green energy, and nuclear, whatever it may be. So some big changes taking place, maybe also some new alliances taking hold. And so I want to use those observations to ask this question, are we entering a new phase in history? Have we really set a new path?

Beckworth: Now, I want to read a quote to you from John Maynard Keynes, right on the cusp of World War I, and this is actually from, I was looking this up and of all places, I found it in a Paul Krugman op-ed from 2008 on the invasion of Georgia, of all things. And if you read that and you go through it and you just change a few names, that column could apply to this, but this is what he wrote. Writing in 1919, the great British economist, John Maynard Keynes described the world economy as it was on the eve of World War I. Quote, “the inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth. He could at this same moment and by the same means, adventure his wealth and the natural resource, a new enterprise of any quarter in the world." And then he goes on, Keynes is just very optimistic. It's this new era, this globalization. We are amazing.

Beckworth: Of course, what happens? World War I happens, completely knocks that back. We have the inter-war period, World War II, and it's not really until long after World War II, we begin to get an opening up of the global economy. So, do you see any changes? And in particular, do you see more self-reliance? It's global supply changes, more diversification there, maybe the US, for example, relying on its own energy or Europe on its own energy. Do you see big shifts happening?

Klein: That's a great question. I will say, first of all, that Keynes' quote was from 1919. So he was reflecting on what it was like before the war, the war having been over and how he wished it was and how destructive it was.

Beckworth: That's fair. That's fair. Yes.

Klein: We talked about this actually in the first chapter of “Trade Wars or Class Wars,” is that you basically have globalization, economic globalization, financial globalization peaking, right before World War I, more or less. And then there's a very, very, very long time before it gets back to where it was. Between World War I, and then the sort of sluggish growth of the 1920s and then the Great Depression and then World War II, and then the division of the world into a large communist block that does not interact with the rest of the world. You don't really get back even to where you were in terms of trade, relative to global economic activity until the late 1970s. And you don't really get past it, is really until the fall of communism, as we understand, like 1989 or whatever, that you really have this pick up in global trade and cross border finance.

Klein: So yeah, you can have a very long period of de-globalization relative to what it once was. I might regret saying this, but I don't think we're there yet. Sort of the positive outlook here is that Russia has made itself a pariah state and no one is really interested in helping them. And there's been a remarkable global consensus that everyone wants to be on the side that's not Russia. So, in that sense, it's de-globalization for Russia, but not for everybody else. Now, there is an interesting question of whether other companies or banks or whatever are going to be like, "Hmm, do we think other things like this might happen from other places? And do we want to try to protect ourselves in advance?" Maybe. That's a harder question. The flip side is that you can imagine the places they might be concerned about also looking at this and thinking, "Man, I don't want to this. What if it happens to me?" So it can kind of work both ways. I don't really know how all these different forces will interact with each other and the second order effects.

You can have a very long period of de-globalization relative to what it once was. I might regret saying this, but I don't think we're there yet. Sort of the positive outlook here is that Russia has made itself a pariah state and no one is really interested in helping them. And there's been a remarkable global consensus that everyone wants to be on the side that's not Russia. So, in that sense, it's de-globalization for Russia, but not for everybody else.

Klein: But on the narrower question of energy specifically, which you asked, I think it's absolutely fair to expect that there's going to be a sea change there. For Europe in particular, it's very obvious, that if you're getting so much of... I'm going to pull this up exactly here. If you're getting about 18, 19% of all your energy coming just from Russia, if you're Europe as a whole. And for some countries in Europe, it's much higher. You're probably thinking that's a very high share, especially when on up of this, it's not even just like, "We get a lot of energy from Russia and that's not good for national security," but Europe before this, there was already a pretty broad consensus that they wanted to move away from fossil fuels because they're dirty and polluting and all this other stuff.

Klein: And so, even before that, there was a consensus, at least in theory, that they were going to reduce their dependence on crude oil and natural gas and on coal. And so when you combine it with a national security risk, I think you're going to see a really big shift there. The fact that the green party in Germany, which for a long time had been adamantly anti-nuclear is now saying that actually we're not going to turn off all the nuclear plants. They basically on schedule, I believe, to turn off the last sub-nuclear plants before the end of this year. And that's not happening now. So, if even there, they haven't necessarily shifted to saying, "We're going to turn everything back on and replace coal and oil and stuff." But there's a shift there and I think you're going to see more of a shift to invest more in renewable energy and energy efficiency technologies like insulation and things like that.

Klein: So that would not surprise me. And that would naturally lead to less trade in so far as the trade, just taking the form of energy, commodities. I don't know how much it's going to affect the rest of the world. Ironically, you could have more trade in so far as, the capacity isn't there yet but in theory, if there are more liquefaction capacity in the US and more import terminals in Europe, the US could send a lot of liquified natural gas to Europe to offset any reduction in Russian supplies. We're not there yet, but if you look at what's been approved, but not constructed, we could easily do that. And that would lead to just more trade, just be a shift of trade, instead of taking a pipeline that's theoretically cheaper, it's more expensive by ship, but more secure. So how that floats through to globalization writ large is tricky. Basically our company's going to be willing to say, "I don't want to do business with other large markets because I'm afraid they're going to start a war and then I'm in the wrong side of that." Maybe. But to be honest, the behavior thus far makes me think that's not going to happen, especially if those large countries are now potentially taking the view that they don't actually... Maybe doing an aggressive war is not something that's worth the trouble for them.

Beckworth: That's a fair point. I looked up right before the show started. Russia's GDP in dollars is $1.7 trillion. So we have about 23, maybe close to 24 this year. So just in comparison, it's a small piece of the global economy. Now there are maybe bigger implications for energy and finance.

Klein: That's another 20 trillion.

Once Imposed, Can Sanctions be Easily Undone?

Beckworth: Yeah. It's very small, just to put things in perspective. Matt, let me ask one more question about sanctions. We'll move on to the financial implications. Let's say this war ends next week so Putin gets deposed or he pulls back. Can you quickly undo these sanctions? It strikes me that we have opened a Pandora's Box... Or maybe a better analogy, the horse is out of the barn. It's going to be hard to get that horse back in the barn. It takes time to reestablish contracts. The whole idea of having correspondent banking, that depends on relationships. You destroy relationships, it takes time to rebuild them up. But what is your sense of that? How easy will it be? And I guess the implication is if it's not easy, then you're going to see some hysteresis in the Russian economy.

Klein: Yeah, that's a great question. I think also it's worth distinguishing between the scenarios you just laid out, because I would imagine that Putin in charge reluctantly, they decide if they've lost too many people on the battlefield and they're going to pull back and not really accept anything else and you get to the status quo before the war. My guess is you would probably lose a lot of momentum to keep sanctions on, but I don't think you'd see a lot of incentive for people trying to be helpful to Russia. Obviously, if there's a regime change or something like that, where there's a fundamentally different kind of government in Russia, that has a very different relationship with the west and wants to make amends or whatever, then I think you could do something different.

Klein: But I completely agree with you. Simply turning the sanctions off is not going to return you back to where you were. I think this is actually really interesting. If you look at what happened after 2014, there were big cuts in relationships between European and British banks, and the Russian financial system as a consequence of that. And maybe some of that was due to sanctions explicitly, but I think a lot of it was just due to, "I don't want to touch this."

Beckworth: Right.

Klein: And I think that's what you're going to see. A lot of stuff we've seen now is companies saying, "I don't want to touch this." What you're seeing with the tech companies or with the air manufacturers and stuff. They could. They're not banned from doing that, but they're just choosing not to. There's no reason that Boeing had to delete access to the repair manuals for the planes, which they did. So that was a choice. And they might come back, but that's a lingering cause.

Klein: I think the flip side here is that if it were somehow the case that you have a real fundamental change in Russia and we actually do want to have a good relationship, then it would be incumbent upon us. And by us, I mean the U.S. and the Europeans and Japanese and so forth to organize a very large aid package to help with reconstruction because the amount of damage that we are inflicting right now is absolutely catastrophic. I don't know if anyone quantified. I saw some estimate. I think it was from the IIF. They thought it was 20% of GDP this year. I don't know. Who knows?

I think the flip side here is that if it were somehow the case that you have a real fundamental change in Russia and we actually do want to have a good relationship, then it would be incumbent upon us. And by us, I mean the U.S. and the Europeans and Japanese and so forth to organize a very large aid package to help with reconstruction because the amount of damage that we are inflicting right now is absolutely catastrophic.

Beckworth: Wow.

Klein: There's a lot of ifs or ins and outs. A lot of what have you's.

Beckworth: Potentially a Great Depression.

Klein: Huge. Huge. That's the point. And so if we're doing that deliberately, as I said, if there's no fundamental change in behavior, then that's a different story. But if there is, we should try to make things better and figure out a way that we...

Beckworth: A Marshall plan for Russia.

Klein: Yeah. Something like that.

Beckworth: Given this best-case scenario you just outlined.

Klein: Yeah. That's right.

Exposure of US banks to Russia

Beckworth: Okay. Let's move to, in the time we have left, two more topics. First one is the exposure of Western banks so European banks, U.S. banks to Russia. So that could be a wild card out there that we don't fully understand, but you've actually looked at the data and you can give us a sense of what's at risk.

Klein: Yeah. And the answer is some, but not that much, basically, which it makes sense. This is consistent with the size of the Russian economy as a whole. So the data come from the Bank for International Settlements and what they do is they ask big, internationally active banks about all their exposures and then they consolidate it across because banks' structures are very complex. And say "Okay. A bank that is headquartered in this country, what are their ultimate claims on borrowers in this country?" And sorting through all that. And those data are there. And I was fortunate someone was willing to walk me through exactly how to read these tables because they're not always very intuitive what the definitions mean.

Klein: And so the short version here is that there's about 100 billion dollars in total of foreign globally active banks claims on Russians net of what they call risk transfers. And then on top of that, there's some other exposure, whether it's credit commitments or guarantees or derivatives. That's somewhere under 50 billion. I should know these date are all as of last summer. So what it was as of February 1st, I don't know. Maybe it doesn't change that much.

There's about 100 billion dollars in total of foreign globally active banks claims on Russians net of what they call risk transfers. And then on top of that, there's some other exposure, whether it's credit commitments or guarantees or derivatives. That's somewhere under 50 billion...I think the pragmatic case here is this Austrian bank called Raiffeisen. They're headquartered in Vienna, but most of their business is actually outside of Austria in central and Eastern Europe and Russia. They have exposures in Russia and Ukraine. And basically, you would not be surprised to find out that their share price has not done very well in the past couple of weeks.

Klein: So these numbers are, on the one hand, if it were all one bank, that would be a pain. But it's not. It's spread out over many institutions. And also importantly, the way those claims are structured in a lot of ways, not only, but a lot of it is you have a Russian subsidiary of your French or Austrian bank. And the Russian subsidiary is the one that takes Russian deposits, that issues bonds to Russian savers that borrow something in the Russian interbank market. And so the equity and the subsidiary, that's something that would get written off. Any profits that the group headquarters expected to get from Russian operations, that's going to zero.

Klein: But at the same time, the asset write-downs, you're only probably losing... Whatever it is, it's 8% of that or something is going to actually hit at the group level, which is very helpful at least to the extent that it's in the Russian scenario. There are claims from the European or American headquarters as well. So it's not like everything's in the Russian subsidiary, but a lot of it is. So I think the pragmatic case here is this Austrian bank called Raiffeisen. They're headquartered in Vienna, but most of their business is actually outside of Austria in central and Eastern Europe and Russia. They have exposures in Russia and Ukraine. And basically, you would not be surprised to find out that their share price has not done very well in the past couple of weeks.

Beckworth: Right.

Klein: But it's not zero. It's down by 50% plus, but it's not zero. It's down much more interestingly than the other systemically important Austrian bank based on the European banking authorities, and there’s two. There's Raiffeisen and there's Erste Group. Erste Groups has no direct exposure to Russian or Ukraine and their share price is down by much less. It's not by 20%, but it's still a lot. But that's consistent with European banks as a whole. Yeah. Threat of war in Europe would be bad for banks. But 20% versus 50% is a significant difference. And incidentally, I have a chart from this in my note. Those share prices track each other very closely within three years before up until mid February. So it's pretty clear what that difference is being attributable to. But again, even Raiffeisen, which is the one that's most exposed and has the biggest concentration, a lot of their stuff is in local subsidiaries. They have presentations about this.

Klein: So the Russian depositors might get hosed maybe or maybe not even. If it's a ruble loan to a Russian borrower that's financed by ruble deposits and the Russian borrower can still repay in rubles, those deposits might be fine. I don't know. As I said, the Austrian shareholders, their cut's not going to be very good, but in the grand scheme of things, this is not catastrophic losses for the bank system. They're there, but they're manageable. We're talking about a hundred billion dollars net exposure, whatever, plus 15 other derivatives for many, many, many trillions of dollars of a bank system. This is a solvable problem. It might hurt a little bit, but it's not going to be a catastrophe.

Beckworth: One of the things you show in that note of yours is that it was about double that around 2014. So one of the blessings, if they're even going to call it that or silver linings from 2014, is that U.S. and European banks began to dial back their exposure to Russia.

Klein: Yeah. A lot did. A few didn't. But yes. That's right. That's right. Exposure was much, much higher before the first invasion of Ukraine. And then you saw a really big pullback. That pullback was concentrated among the U.S. and British banks and I guess Japanese banks as well. German and Dutch banks were pulling back earlier, basically since the financial crisis, probably just because those banks just generally overextended, pulled back Russia's part of that.

Beckworth: Yeah.

Klein: French banks pulled back a little bit, not a lot. And French banks, we're really talking about Societe Generale. Well, it's not only them. But the Italian and Austrian banks, which again in practice means Union Credited and Raiffeisen, they did not. But even so, they did adjust their exposure. So instead of lending in Euro or dollars from their home country, they shifted it to being, "We're going to lend on rubles, financed by ruble deposits from the subsidiary that we can just cut off if we need to." And so that shift happened. Yeah. The short answer is there was already this adjustment taking place.

Implications for Inflation

Beckworth: Okay. Let's come to our final topic. And this brings us full circle to our previous conversation, Matt, that we had last time you were on the show and that's inflation. So I want to see your hot take on the implications of all this for inflation. And I can see two stories. One, the most obvious is this is a negative supply shock, just like the pandemic so we're going to have inflation go up and it's going to really confuse things for the fed and potentially allow the fed to make a bad choice. On the other hand, and another story you could tell is if this sanctioning and our response engineers a Great Depression in Russia, it could lead to a recession in Europe, which then could have some bearing back on us, maybe less of an effect. What do you see happening? Where does the dust settle down?

Klein: I'm a simple man so I'm just going to look at the market prices. And the market prices are stocks went down a lot, specifically bank stocks, which are very cyclically sensitive and bond yields went down a lot. Actually I think the pandemic is the right analogy in the sense that was both a supply shock and a demand shock. But how that plays out in terms of inflation is a trickier question. Because in the short term, it is going to show up in things energy prices and other commodities, not just energy. I think food is one that could be potential. It's not going to affect the U.S. directly because the U.S. is a net wheat export. We do not depend on Russian and Ukrainian wheat, but there are places that do. And for them, it could be very painful. The last time there was a big increase in wheat prices, which wasn't even due to this conflict or anything, but you had riots in the streets and throughout the Middle East. I would be very reticent to put a net effect on inflation. I mean the other thing too is this is the real big question is how long does this last?

Beckworth: Right, right. Yeah. We're assuming rather benign scenarios here.

Klein: Yeah. It's funny because before I got into all this stuff, I was looking at what internship I want to do in college. I almost ended up at the Defense Intelligence Agency. And if I were there, I would have a better sense of what the balance of forces is in terms of what the Russians can sustain and so forth. But I don't know. Maybe it turns out they'll have to give up, maybe it turns out they'll be there for 10 years. I have no idea. Which by the way, that'd be catastrophic, because if they're there for that long, there's going to be an enormous amount of destruction. There's already been enormous amount of destruction, but if it turns into another Afghanistan for them, that would be terrible for Ukraine.

In the short term, it is going to show up in things energy prices and other commodities, not just energy. I think food is one that could be potential. It's not going to affect the U.S. directly because the U.S. is a net wheat export. We do not depend on Russian and Ukrainian wheat, but there are places that do. And for them, it could be very painful. The last time there was a big increase in wheat prices, which wasn't even due to this conflict or anything, but you had riots in the streets and throughout the Middle East.

Beckworth: Even worst-case scenario would be a nuclear war. That would be the extreme case. Hopefully it doesn't happen.

Klein: Yes. Yes. Yes. I would like to think that would not...

Beckworth: Smarter heads would prevail in Russia.

Klein: Yeah.

Beckworth: Yeah. That would be the case. And I heard you in another podcast, you mentioned this back too, that historically Russia has been a second strike nuclear force. Is that right? Typically, he's not going to be the first one to launch a nuclear weapon. So that should give us some hope.

Klein: Right. Yeah. Historically, which different world, but historically it was always the U.S. that was basically saying, "We will be the ones to launch nuclear weapons first because our conventional forces... If the Soviets wanted to send tanks streaming through the fold of gap, we would not be able to stop them and so we would have to launch nuclear weapons." Whereas the flip side is the Russians say, "We don't need to launch first because we can just send in the tanks." So I don't know if that's how they feel now. I think it's pretty clear that the U.S. is not going to start a nuclear war by launching nukes at Russia. If Russia attacks NATO countries, who knows what's on the table? But I think also it's pretty clear that NATO countries are not going to directly engage Russian forces at this. So at that point, I think, this is why I think this is Afghanistan in some ways. It's imperfect.

Klein: That was the last time the Soviet Union attacked a neighbor. And they knew they were fighting people who were being trained and armed by Americans. Although there were some cutouts in between to give a degree of plausible deniability, but we all knew that's what was going on. In this case, you wouldn't even need that because Ukraine has a very large border with four different NATO countries. They've already been accepting plenty of arms. There is a government in Ukraine that is being defended here. It's not arming an insurgent group in another country. So this could last for a while. How it plays out... There are many, many downside scenarios. The most optimistic scenario you come up with is still very dire compared to the world as it was two weeks ago. So this is terrible and I hope that we can find a way out of it soon, but there's really... Having started the war, Putin has made the world a much worse place and we're just living with that now.

Beckworth: Well, Matthew, I'm a little bit older than you and I was a very young person in the eighties, but old enough to be aware of the Soviets. I remember watching Rocky IV. They were the bad guys. We were the good guys. Listening to Sting sing the song about the Russians, if they love their children too. And it's wild to be coming full circle back. Again, it's a highly unlikely scenario that they're going to start a nuclear war, but it's just... I don't know, bizarre, surreal to see us come full circle this way. Well, with that, our time is up. Our guest today has been Matthew Klein. Matthew, thank you so much for coming back on the show.

Klein: Thank you very much for having me.

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