Americans have been galvanized lately at the sight of Russian troops, directed by Vladimir Putin, blatantly occupying the Crimean Peninsula in Ukraine and annexing it as part of Russia.
For those who thought that such brutal tactics were a thing of the past, the Russian invasion of Crimea serves as a reminder that the impulse among autocrats to build empires is alive and well.
For better or worse, there is little the United States can do militarily to change the outcome in Ukraine. As was seen in Hungary in 1956, Czechoslovakia in 1968, and Afghanistan in 1979, when Russia decides to exert brute force in its sphere of influence, the United States can voice support for the victims, but is otherwise unable to intervene except at costs that are too high relative to the national interests involved.
But this does not mean the United States is helpless. No sooner had the Russian invasion become clear than the White House announced the possibility of economic sanctions against Russia. The sanctions have yet to be spelled out completely, but could include freezing personal assets of certain Russian officials and oligarchs and prohibiting certain transactions by United States companies and government agencies with Russian counterparts. By implementing such sanctions, the United States has moved in the direction of a new kind of warfare — not kinetic war involving ships, planes and missiles — but financial war involving cash, stocks, bonds and derivatives. The policy question, and an important question for investors, is how far can this type of financial warfare go and how effective can it be? What will the impact of financial war be on markets in general and investors in particular?
The answer is that such financial warfare tactics will not go very far and will not be very effective. The reasons for this go back to the Cold War doctrine of Mutual Assured Destruction or “MAD.” During the Cold War, the United States had enough nuclear missiles to destroy Russia and its economy and Russia had enough missiles to do the same to the United States. Neither adversary used those missiles and the leaders were quite careful to avoid escalations that might lead in that direction. Proxy wars were fought in places like Vietnam, the Congo and Afghanistan, but direct confrontation between the United States and Russia was never allowed to come to a head. The reason was that no matter how devastating a nuclear “first strike” might be, the country under attack would have enough surviving missiles to launch a massive “second strike” that would destroy the attacker. This is what was meant by “mutual assured destruction” or the balance of terror. Neither side could win and both sides would be destroyed, therefore they went to great lengths to avoid confrontation and escalation in the first place.
In financial warfare between the United States and Russia, a similar balance of terror exists. It is true that the United States has powerful financial weapons it can use against Russia. The United States can freeze the assets of Russian leaders and oligarchs that can be found both in United States banks and foreign banks that do business in dollars. The United States can deny Russian access to the dollar payments system and work with allies to deny Russian access to the SWIFT system in Belgium that processes payments in all currencies, not just dollars. Many of these tactics have, in fact, been used against Iran and Syria in the financial war that has been going on in the Middle East and Persian Gulf since 2012.
But, Russia is not without financial weapons of its own. Russians could refuse to pay dollar-denominated debts to United States and multilateral lenders. Russia could dump the billions of dollars of United States Treasury notes they own thus driving up United States interest rates and hurting the United States stock and bond markets. Most ominously, Russia could unleash its hackers, among the best in the world, to crash United States stock exchanges. On August 22, 2013 the NASDAQ stock market crashed for half a trading day and no credible explanation has yet been offered for the crash. Hacking by Syrian, Iranian or Russian cyber warriors cannot be ruled out. This may have been a warning to the United States about enemy capabilities.
In short, the United States has no interest in intervening in Ukraine militarily and even its economic response will be muted because of new fears of mutual assured financial destruction emanating from Russia and elsewhere. Putin has thought all of this through and has taken Crimea as his prize.
Merely because financial warfare between the United States and Russia will not be allowed to go too far, does not mean that the situation in Ukraine will not impact markets. Stock markets dislike uncertainty of any kind and Russia’s intentions with regard to the rest of the Ukraine outside of Crimea certainly add to uncertainty. Russia’s victory in Crimea may embolden China to assert territorial claims to certain islands in the South China Sea, which will increase tensions with Japan, Korea, Taiwan and the United States.
There is always the possibility of a financial attack being launched by mistake or miscalculation, which could cause events to spin out of control in unintended ways.
Investors may not be able to change this dangerous state of the world, but they are not helpless when it comes to preserving wealth. A modest allocation of investable assets to physical gold will help to preserve wealth in the face of financial war or unexpected catastrophic outcomes.
Gold is not digital, cannot be wiped out by hackers, and is immune to crashing stock markets and bank failures. Russia has increased its gold reserves 70% in the past five years. China has increased its gold reserves over 200% in the same time period. Do they know something you don’t?
James Rickards is portfolio manager for the West Shore Real Asset Income Fund and the author of The Death of Money forthcoming April 8 from Penguin Random House. Follow on twitter @JamesGRickards.