Russia in Global Affairs

In 1899, Rudyard Kipling, an English writer, wrote a poem entitled ‘The White Man’s Burden,’ in which he praised the white men — notably, the British and Americans — who were to “Send forth the best ye breed … to serve your captives’ need.” The poem extolled the moral duty of the White race to lead the “new-caught, sullen peoples … toward the light” even by brute force if necessary.

The writer left to the readers to ponder why and how it became the White race’s duty to carry the ‘light’ — understood as the fruits of its civilization — worldwide as if the answers to these questions were obvious. However, they were open to conflicting interpretations even then. For example, another English writer, Hilaire Belloc, summed up the same Kipling’s feeling of the White race’s superiority in the poem ‘The Modern Traveler’ (1898) as “Whatever happens, we have got the Maxim gun, and they have not” stating in plain English that it is the ‘power of the sword’ that makes the White race more “civilized” that the others.

Indeed, technical superiority provides the means to impose power, but “a spoonful of sugar” needs to complement such a bitter medicine to “go down in a most delightful way.” And that spoonful of sugar was found in the presumed human desire to be rich.

I Will Teach You to Be Rich

In 1776 Adam Smith, a Scottish economist, published a treatise ‘An Inquiry into the Nature and Causes of the Wealth of Nations,’ where he stated a seeming paradox that “the accommodation of the industrious and frugal European peasant exceeds that of many an African king, the absolute masters of the lives and liberties of ten thousand naked savages.” How it could be, reflected the author, that the authority of a powerful king fails to satisfy as many of his needs as the market forces do for a frugal peasant? He concluded that the prosperity of nations depended on their ability to produce rather than on their ability to rule.

The conclusion proved to be visionary. Up to that moment, the dominant theory, mercantilism, asserted that a nation could become wealthy only at the expense of other countries. Two approaches were considered. The first, preferred by traders, was to move abroad goods of superior value than to the ones imported, meaning that the difference in value would be covered with the bullion. The second, liked by noblemen, put emphasis on any overseas warfare successful enough to generate the value of spoils greater than the war-related expenses.

The new theory sketched a third, brand-new approach to go from rags to riches. This approach did not require venturing on dangerous exploits elsewhere; more so, it did not require hoarding bullion at home at all. Instead of looking for ingenious ways to accumulate gold and silver, it recommended that countries shift their efforts to domestic production. Thus, the argument went, hard work coupled with good management skills would bring the nation up to the same if not greater opulence as foreign exploits could do.[1]

Theoretically, this new path to wealth was open to every nation regardless of their capacity to sail the seas or to fight. In reality, it was a pipe dream.

The method worked only under the condition that a nation had all resources necessary to cover every contingency at home. Such self-sufficient nations did not exist at the time. For this method to work, cooperation was in order: countries were obliged to form unions so that every region would specialize in trades in which it had comparative advantages and imported everything else. However, to function the unions had to live according to specific rules, so that all participants along technology chains — in extraction, processing, production, transportation, sale and logistics — would not attempt to free-ride or prey on their more dependent partners.

That was a challenging task to accomplish. The great European empires of that and later times — Britain, France, Germany, Russia — wrestled incessantly to expand their spheres of influence in order to get a larger piece of the pie than was their rightly due. Smaller European countries flocked to align with empires to get what they wanted and to get away from what they did not want. The rest of the countries — mostly non-Christian and, hence, not subjects to the principle of Westphalian sovereignty — received only crumbs unless they, like the Ottoman Empire, could defend their interests by the power of the sword. Another mechanism, a more civilized one, was required to cool the royal hotheads and that mechanism was found in the emerging markets for money.

The Rising Power of Lombard Street

When Adam Smith wrote his treatise, the concept of wealth did not require an explanation. His rich contemporary was “worth a great deal of money”, meaning that his wealth consisted of cash and easily cashable assets such as land, real estate and chattel. Financial assets were scarce and comprised of mostly trade credit issued under lien to merchants — with the lien consisting of tradable goods whose value creditors found sufficient to compensate in the case of bankruptcy — or venture capital provided to aspiring entrepreneurs next door. Such investments were supposed to be either fully returned with interest on maturity or granted its holder the right for a share in the returns on that venture. This requirement greatly limited the use of credit.

Such credit did not require complex arrangements — as lenders and borrowers knew each other — and sufficed to meet the needs of slowly developing economies. The situation changed in the XIX century when a slew of technological innovations upended the traditional order. The demand for credit rose manifold and the mechanism to meet this demand was found in the money markets.

In 1873, Walter Bagehot, an English journalist, wrote ‘Lombard Street: A Description of the Money Market,’ in which he asked why was it that in England “where in all but the rarest times money can be always obtained upon good security” (specifically, in Lombard Street — the main financial district in London) and not in other rich European countries where “much more cash exists out of banks” like in France or Germany? The difference, reasoned Bagehot, was that European cash was scattered through a whole nation and, thus, was unattainable; whereas English cash was concentrated in banks, giving English bankers a great power.

“Why did it happen?”, thought Bagehot and concluded that the answer lied in a specific feature of the English financial system that incentivized the countryside owners of cash to deposit it with local banks. These banks, when incapable of investing raised money locally, deposited the idle cash into large banks and brokers of Lombard Street. Such deposits at London’s banks were considered safe because they were effectively insured against the loss by the Bank of England, a special bank established by London merchants to manage the royal finances in 1694 and which acquired the status of ‘the bank of all other banks’ following the introduction of the Bank Charter Act in 1844. In this way, the Bank of England assumed the responsibilities of what became later known as ‘the lender of last resort.’

That was an innovation that created a brand-new, two-tier system of banking, whose efficacy hinged on the existence of a super-bank. That super-bank was more than an old-fashioned bank: its main function was to assure bank depositors that their deposits were safe regardless of what investments their banks had made. The direct connection of the owners of idle cash to entrepreneurs in need of money was no longer needed anymore.

The resulting expansion of investment opportunities had far-fetching consequences not only for long-term investments. It changed the definition of wealth.

The number of nouveaux riches whose wealth consisted mainly of financial papers grew exponentially. Moreover, the appeal of income-bearing ‘financial assets’ — or promises issued by financiers that generated profits — lured ‘old money’ to London from the continental Europe. As the influx of cash to London’s banks and financial intermediaries increased, so did the strain on its ‘central bank,’ the Bank of England, that — nolens volens — had to accept the new duty of ‘the White man’s burden’ and protect all of European wealth against financial crises. This bittersweet obligation brought about the international admiration of the British financial system and faith in the soundness of its currency, the pound sterling, all over the world.

The evolution of new systems is always besieged by issues unforeseen at the time of their introduction and the British system of banking was no exception. Other countries wanted to emulate the British success — primarily Germany, which set up its own bank of banks, the Reichsbank, in 1876 — and competed for money worldwide. For a while, the sheer size of funds already attracted to London and the reputation that the city enjoyed as a global financial center helped to maintain trust, inter alia, in the stability of the nascent global financial system kept under control by the market operations of the respectable Bank of England.

However, Britain was gradually losing its lead, first in technology and later in maritime trade. Its financial appeal was declining as well. By force of tradition, the pound sterling was still regarded the currency of choice in international trade in the 1920s (and even in the 1960s for certain items of trade) when a growing gap between the British global liabilities and assets pushed the Bank of England to relinquish the gold standard — that it maintained for most of the period since 1717 — in 1931. The world of wealth was falling apart. The beginning of the Great Depression in the 1930s and stress that it imposed on the world of wealth required a new, more innovative approach to international money management.

Wealth of the World, Unite!

In 1900, the British Exchequer failed to find money in Lombard Street and had to place a £30-million loan in Wall Street (the main financial district in New York) to finance the unexpectedly protracted war in the South Africa. Rumors spread that New York was destined to oust London as the financial center of the world; however, the US bankers of the time were still skeptical. Although soon they had their own bank of all banks — the US Federal Reserve System instituted in 1913 along the lines of the German Reichsbank — American financiers felt that their British counterparts were shrewder and more devious in their negotiating tactics. It also did not help American self-esteem when the British dragged their feet in repaying their WWI debts to the US and stopped servicing this debt in 1934: President Roosevelt complained bitterly that America always lost out on deals with the British.

It was not until the British first recognized in domestic debates that “such leadership as we possess has been affected by the position which America has gained” (in the Macmillan Report 1931) and then internationally during the post-WWII conferences related to the formation of a new system of global financial management later dubbed as the Bretton-Woods system “that the British ought not to take an initiative… It was for the Americans to take the initiative.” The Whitehall was ready to pass the baton of global financial leadership to the White House.

The new leader’s economy was rapidly expanding and technologically advanced. The country ran a stable trade surplus, making good on its possession of a vast array of mineral and human resources. Moreover, the Americans were much richer than anybody else in the world after WWII: their real GDP per capita was over 15,000 dollars in 1950 (in US$ of 2011, see Maddison Project Database 2018.) The American financial system was capable of gathering seemingly infinite amount of money to lend to countries in need, especially to the war-ravaged Europe. Moreover, the British were willing to share their precious financial expertise in exchange for a special place in this new, US-dominated system. In the aftermath of WWII, it came as no surprise that the American government felt sufficiently secure in its power to invite all countries to participate as minority shareholders in the formation of a new system of global financial governance.

The invitation was accepted almost unanimously (apart from the countries that later formed the Eastern Bloc)[2] and the new system, named after the conference held in Bretton Woods, New Hampshire where it was originally discussed, was put into operation in 1944-1958. It retained the basic features of the preceding British system — the lender of last resort, the reserve currency — and established international financial organizations that were intended to fulfill three functions that found to be lacking in the inter-war period.

First, the system had to be equipped with a mechanism that controlled the exchange rates. The fear was they could again be used for the ‘beggar-thy-neighbor’ trade policy that stifled the global trade in the 1930s. That control function was assigned to the International Monetary Fund (IMF), which was tasked with monitoring the members’ exchange rate policies and providing them with short-term loans necessary to cover temporary trade deficits. In this way, the members were enabled to maintain the fixed exchange rate of their currencies to the US dollar. As American trade deficit was considered unlikely, the value of the dollar was fixed directly to that of gold with shipment of gold being envisaged as the act of last resort.

Second, the system designers deemed important to keep control over long-term capital flows. The concern was that a sudden change in the market mood could unnerve investors and precipitate a capital flight from a certain currency imperiling that nation’s ability to maintain the fixed exchange rate. To that end the government-supported capital flows had to be managed through an institutional provider of long-term investment funds called the International Bank for Reconstruction and Development (IBRD.) Later, it was recognized that funds coming from non-governmental sources (not covered by the IBRD) could flow in and out erratically as well and, to account for this contingency, two other long-term private-government lending organizations were established.[3] Nevertheless, it was revealed with time that the national governments should also retain ability to impose capital controls when the exchange rates of their currencies moved beyond a specific band.

Finally, the Bretton-Woods designers pondered over an institution that would manage international trade, but disagreements over protective tariffs proved this idea infeasible. A smaller number of countries came up with a simpler agreement on freer trade for some products known as the General Agreement on Tariffs and Trade (GATT.)[4]

Outside the formal institutions of the system, a number of regional agreements were concluded. The chief among these agreements that had long-lasting institutional consequences was the Marshall Plan, or the European Recovery Program, which was an investment program funded by the US government and offered to war-torn Europe in 1948. On American insistence, the funds were allocated to projects whose products were explicitly excluded from European tariffs. As a result, the recipient countries were obliged to clear their trade policies with a special financial-aid-coordinating agency that later became known as the Organization for Economic Cooperation and Development. A similar investment program was instituted in Japan.

It should be noted that the system was designed in a manner that virtually impelled national authorities to follow its rules or face severe negative consequences to their economies, which is an anathema to governments that are elected and, hence, dependent on the public mood. Consequently, the member countries abided by those rules that seemed to be sufficient for smooth operation of the system.

But there was a glitch: the preeminent position of the US as the guarantor of the system made it immune to potential rule violations.

When the US dollar attained the role of international reserve currency, demand for dollars was artificially raised. Other nations competed to gain a reserve stock of dollars that could only be raised when they exported more than they imported. A greater demand overvalued the US dollar relative to other currencies, but, for a few years, the US reserves of gold continued to grow as other countries redeemed their WWII-related US debts for gold. The trend was reversed in 1950 when the American government needed money to pay for the Korean War and the flow of gold was reversed.

As America lost its stock of gold, doubts sprung up that the country would be unable to sustain the fixed exchange rate of dollar for gold. Currency speculators became active, betting on the margin between the official and shadow market prices of gold. To counteract their influence, a group of central banks created the London Gold Pool in 1961 with the intent to regulate the price of gold in the London bullion market. For some time, their interventions kept the speculators at bay, but as the US increased money supply to fund the Vietnam War, France was the first to break the ranks of the Pool and withdrew in 1967.[5]  Other countries followed.

Facing an unsustainable outflow of gold from the country, US President Richard Nixon announced a “temporary” suspension of the dollar’s convertibility into gold in 1971. The specter of the repeat of the Great Depression was raised and the member-countries tried desperately to resuscitate the system but to no avail. The suspension of gold convertibility became permanent in 1973, bringing the Bretton-Woods system to the end.

Yet, an interesting phenomenon was noticed when this ‘non-system’ — as economists named the years after the Bretton-Woods — was at work: the member-countries did not split into warring factions as they did in the 1930s, but navigated the turbulent waters as a group that became known as the collective West. Within that group, the trade and capital flows continued to flourish despite the exchange rate fluctuations. The global wealth seemed to have coalesced in the West, attracting the remaining bits and pieces to its orbit by the sheer force of gravity. The idea of an “industrious and frugal European peasant” becoming rich within the realm of a Western democratic governance seemed to capture the imagination of the world.

The ‘Non-system’ at Work: Quo vadis?

The ‘non-system’ that started 50 years ago has led to albeit unintended but long-lasting institutional changes, particularly in Europe and America, that need to be mentioned.

After the Marshall Plan was ended in 1951, its force of momentum was sufficient for the European countries to continue their integration and to form the European Economic Community (EEC) in 1957, a consultative structure that was intended to align regional economic policies.[6] In parallel, after exchange rates were allowed to fluctuate, the key EEC countries, including Germany and France, agreed to establish in 1979 the European Monetary System that pegged their currencies to a weighted average of the currencies, named the European Currency Unit.[7]

Confronted with the problem of how to preserve the leading role of its currency after the demise of the gold standard, America had to find a way to persuade its export-oriented partners such as Japan and newly enriched oil-exporting Arab countries to continue accumulating their trade surpluses in the US dollar instruments. A two-pronged approach was gradually developed. Political instability in the Far East and Middle East was exploited to persuade the friendly leaders of these regions to rely on protection that the US military complex could provide. In exchange for loyalty to the US dollar, the US government took an implicit obligation in the 1970s to supply these countries with advanced military equipment and to intervene if any aggression happens there. In parallel, responding to the criticism that American banking regulations made domestic banks less innovative and competitive than they were previously, the US authorities introduced a series of laws in 1980s that reduced the regulatory oversight over the US financial sector. Relaxed laws permitted banks to develop new financial tools that would, inter alia, entice rich foreigners to keep their wealth in America.

From the economic point of view, the situation of ‘non-system’ coupled with the democratic form of governance — that made political leaders sensitive to the demands of rich donors — created an environment that was the most favorable for the growth of financial wealth, especially that held in US dollars. Since the 1980s, the total value of these assets had shot through the roof compared to the value of non-financial assets (such as real estate.)[8] ‘Making money from money’ (that what the US financial sector is doing) has become the most profitable enterprise in America. Meanwhile, other industries that relied on product quality and good service support became less competitive. New financial activities — such as corporate raiding through leveraged buyouts, issuance of junk bonds, subprime mortgages and other instruments that provide high return on investment without producing anything tangible — proliferated at the expense of American manufacturing that was gradually shrinking in importance.

But whether that ‘non-system’ remains viable in the longer-run is open to debate. Engineers know that when a system loses control — which is what a ‘non-system’ is about — it accumulates imbalances that lead to its eventual breakdown with negative consequences. When it happens and a social ‘non-system’ (such as a financial system) disintegrates, it gives rise to social conflicts that will challenge the existing order. One conflict — in Ukraine — has already pitted the elites of the collective West, who are guardians of l’ancien régime, against the leaders of the new ‘axis of evil’ (China, Russia, Iran, etc.) who would like to rearrange the global power in favor of their countries. However, there are other, insidious, fault lines that pass inside the collective West. Financial assets are somebody’s liabilities and their overall growth does not guarantee universal prosperity. In order to make money from money, it is necessary to have initial capital already at hand. On the contrary, in order to create more debts, others have to be already indebted.

Thus, it comes as no surprise to find that the newly minted financial wealth accumulates in the hands of these who are already rich and those who are indebted sink even deeper into debt.

Professional financial consultancies, such as UBS or McKinsey, confirm that the growth in Western financial wealth has been accompanied by steadily growing wealth inequality between haves and have-nots. Such a skewed distribution of wealth fuels discontent among the poor and unnerves the super-rich, who feel that the current bonanza may not last long. It nurtures an internal social conflict that eventually bursts open unless the power brokers manage to vent the accumulated frustration out of the ‘non-system.’

The World at a Crossroads

The previous paper Gold and Iron at War: Quest for Power hypothesized that the Ukrainian conflict was an episode in the power struggle between the power of gold (super-rich) and the power of iron (authoritarian leaders), with the power of iron setting a trap to gold as the conflict weakens one of the gold’s defenses (outreach to both sides of the conflict.) The discussion above suggests that this hypothesis is not supported with evidence. Historical assessment of the evolution of the global financial system reveals neither formal nor informal institutions of power associated with gold. Money plays the dominant role in controlling the choice of political authorities in democratic countries, but it does not rule in open.

Charles Kindleberger, an American economist, used to describe the relationship between the two components of power in democracies as symbiotic, saying that “governments propose, markets dispose.” From his point of view, policy makers (authorities) set conditions and market participants (financial managers) respond to these conditions by either rewarding politicians or ruining their careers. In this perspective, exclusive international gatherings of financial moguls and political bosses — such as the annual World Economic Forum in Davos — are intended for politicians to gauge market participants’ reaction to potential policy changes and for financiers to obtain advance information about policies yet to be announced.[9]

This leaves Western policy makers as solely and fully responsible for the management of global affairs. Prior to the Ukrainian conflict, two grand policies competed for global attention. The first, EU-based, vision was to follow the ‘Green Agenda’, understood as the decarbonization of energy, waste recycling and efficient use of resources. That approach contrasted with the American vision to support the ‘Democratization’ as the way “to secure the peace, deter aggression, expand open markets, promote economic development.”

The beginning of the Ukrainian conflict brought to halt the European approach, leaving the second policy as the only viable alternative. However, the American political vision becomes increasingly blurred as the ‘non-system’ does not indicate which tactical moves will be approved by the world of finance. Not seeing a clear path forward, policy makers remain clueless regarding their duties to the global wealth. Having only political objectives in sight, they come up with knee-jerk reactions to unexpected events and, in this interpretation, the initiation of Ukrainian conflict is an unfortunate product of political jockeying oblivious to its financial implications.

Other US policies related to Ukraine and elsewhere support this conclusion. When the vision is blurred, old policy prescriptions that were successful years ago are recycled without much thought about their detrimental effects on other fields. The Atlantic Charter agreed by the US and Britain in 1941 comes across as an example. Apparently, it is seen by American politicians as the cornerstone of this country’s influence in the world, which explains why the goal to weaken Russia “to the degree that it can’t do the kinds of things that it has done in invading Ukraine” — as pronounced by the US Defense Secretary Lloyd Austin on April 25, 2022 — has been held simply because it is consistent with point 8 of the Charter.[10]

But other policy issues that are not treatable from a position of military might leave the US authorities unsure on how to react. For example, European debates over the necessity to build a confederate EU army — based predominantly on French and German industrial power — receive a muted response in Washington. On one hand, the US authorities realize that their burden of unilateral military expenses is too heavy to carry, but, on the other hand, this idea goes contrary to the principle of hegemonic military might concentrated in America. And the lack of that strategic vision does not allow American policy makers to side unequivocally with one or another party to the debates.

The discussions related to financial issues are handled even more ambiguously. How to use the Russian sovereign assets frozen in the West is a case in point. From the political point of view, their confiscation is an expedient move to rub the nose of a political adversary. However, its implications are heavy from the financial point of view. The proposed plan to issue Ukrainian bonds backed by the Russian assets looks very similar to the issuance of mortgage-backed securities — for which Western financiers developed a short-lived taste in the 2000s (only to backfire with catastrophic consequences in 2008) — but they are birds of a different feather. Financiers are not used to daring the sovereigns who are still in power.

Before they venture forth to put a hand on the Russian assets, they would like to make sure that the Russian bear will not strike back.

From longer-term considerations, the consequences of such a move are similarly unpredictable for financial markets. Instead of continuing to attract foreign assets towards the Western system of wealth, the confiscation might scare off rich foreigners, who realize that their wealth is at the whim of Western political actors. This thought could prompt them to seek unusual hiding places and scatter the wealth that was accumulated in the West up to now.

What is more important for the global leader — the soft power of wealth or the hard power of the sword? A historical comparison of the predicament that the current bearer of ‘the White man’s burden’ faces is relevant. Ever greater uncompromising posture of Washington as a hegemonic power — on pretext that it defends the existing ‘rules-based international order’ — brings to mind a similar stance that British leaders took during the heydays of the British Empire in 1870-1914. Then, as Eric Hobsbawm, a British historian, noted “Britain … exchanged the informal empire over most of the underdeveloped world for the formal empire of a quarter of it.” In his opinion, that was a poor bargain. Upholding the dominant global position with the power of sword flatters the ego of American power brokers but, from the financial perspective, this game might not be worth a candle.[i]

The article was originally published in Russian in Issue 3 (May/June 2024) of Russia in Global Affairs magazine.