Chapter 5: Multipolar World, Crashed

Chapter 5 MULTIPOLAR WORLD

Russia’s return to the world stage in the early 2000s owed even more to global economic growth than did the rise of China. Russia poured oil and gas into world markets. Its banks and industrial corporations borrowed enthusiastically in Europe and the United States. Like China it held a huge reserve of dollars, but unlike China its financial and economic interrelationship with the United States was indirect. Russia did not earn its dollars by exporting to the United States. It sold its gas and oil to Europe and Asia. Furthermore, whereas the Chinese Communist Party approached the West with self-confidence, the wounds of the Soviet Union’s defeat in the cold war were still fresh. There were no fond memories of a “Nixon-Kissinger” moment in the Kremlin. It was not by accident, therefore, that it would be Russia’s president Vladimir Putin, the cold war KGB operative, who would pose the question that China and America preferred not to speak out loud. What, Putin demanded to know, were the implications of a rebalanced and reintegrated world economy for the geopolitical order? Putin not only posed the question. In so doing he exposed a deep lack of agreement within the West—inside Europe and between Europe and the United States—over what kind of international architecture should frame economic and financial development, not just in the world at large but in particular on Europe’s very doorstep, in Eastern Europe, the showcase for capitalist transition in the post–cold war world.

I

In Europe, unlike in Asia, the triumph of “the West” over communism was absolute. It was a triumph of both hard and soft power, military, political and economic might. Though Germans might give more credit to Gorbachev and détente diplomacy, and Americans more to Reagan and Star Wars, the Atlantic alliance was united in victory. No one benefited more from the end of the cold war than a newly reunified Germany, and it was German-American cooperation that secured the win. In 1990 French president François Mitterrand favored a conciliatory vision of embracing the former Soviet bloc in a common European security policy that would supersede NATO as well as the Warsaw pact.¹ But neither Helmut Kohl nor George Bush wanted anything to do with that. The West had won. It would set the terms for Europe’s reunification.

The fall of the Wall and the dissolution of the Soviet Union in December 1991 left Russia shrunken and isolated. Not since the dark days of Lenin’s ruinous peace of Brest-Litovsk in 1918 had Russia been so humbled. Under Yeltsin, Moscow’s relations with the West were friendly. But Russia’s economy was a shipwreck. In the words of George Soros, Russia was “a centrally planned economy with the centre knocked out.”² In the so-called transitional recession, inflation soared and Russia’s real GDP fell by 40 percent between 1989 and 1995. On “Black Tuesday,” October 11, 1994, in one single session of frantic currency trading, the ruble lost more than a quarter of its value against the dollar. It was not until 1995 that Russia’s economy stabilized. A modest revival fueled by large imports of foreign capital enabled Russia to catch its breath, only to be thrown off balance yet again by the Asian financial crisis of 1997.³ Struggling to hold the exchange rate, the Russian central bank introduced exchange controls and begged an emergency IMF loan.⁴ But in August 1998 Yeltsin’s government lost its grip. On August 17 Moscow devalued and declared a ninety-day moratorium on the payment of foreign debts owed by Russian banks. The ruble went into free fall, plunging from 7 to the dollar to 21. The cost of imports surged. Russians who had borrowed abroad faced bankruptcy. Then on August 19 the Russian government defaulted on its ruble-denominated domestic debts. By October 1998, with 40 percent of the population counted as living below the subsistence minimum, Moscow was reduced to appealing to the international community for assistance to pay for food imports. As inflation soared to an annualized rate of 84 percent, Russians lost confidence in their national currency. As the new millennium began, dollars made up 87 percent of the value of all currency in circulation in Russia. Outside the United States, Russia was the largest dollar economy in the world. International investors in Russia were required to pay their local taxes in American currency. Russia became the ultimate experiment in dollarization, a nuclear-armed, former superpower with a currency supplied from Washington.⁵

Source: http://www.ggdc.net/maddison/maddison-project/home.htm.

With the exception of newly independent Ukraine, Russia was the worst hit of the post-Soviet countries, but the early 1990s were tough across the former Eastern bloc.⁶ As they stripped away the institutional structure of planning, the economies of Eastern Europe and the former Soviet Union experienced economic trauma. On average between 1989 and 1994, output fell by more than 30 percent. Inflation, unemployment and social inequality rocketed as real wages plunged and Communist-era welfare systems disintegrated. In the Baltic states, the hit to the wage level in the 1990s was staggering. Wages fell by 60 percent in Estonia and 70 percent in Lithuania. For many millions, emigration was the best option, illegal if need be.

This was the backdrop against which NATO and the EU decided on enlargement to the East, stabilizing the immediate crisis, offering a future direction and permanently redrawing the geopolitical map.⁷ The double expansion of EU and NATO was not a coordinated affair. It was driven as much by the East Europeans themselves as by Washington, Berlin and Paris. Poland, Hungary, the Czechs and the Slovaks—the Visegrád group—began pushing for NATO membership as early as February 1991. The EU followed up with an association agreement. But the EU’s decision for enlargement did not follow until 1993, with its conditions being spelled out in detail only in 1997. While some outside observers called for a Marshall Plan to launch economic development, what the EU offered to aspirant members in Eastern Europe was technical and expert assistance as they embarked on the transformation of everything from public finances to transport infrastructure, property rights and the legal system. Focusing only on the military dimension, NATO could move more quickly. Already in 1999 the Poles, Hungarians and Czechs were admitted as full members. The really big bang came in 2004. On April 1, 2004, Bulgaria, Estonia, Latvia, Lithuania, Slovakia, Slovenia and Romania joined NATO. A month later all but Bulgaria and Romania also joined the EU. The two stragglers were judged ready for EU membership in 2007.

It took fifteen years from the end of the cold war. There were second thoughts in Washington, and many West European governments were reluctant to embark on the eastward expansion. The costs were likely to be huge. The risk of provoking Russia was obvious. In 2003 the divisions over the invasion of Iraq were deep and embarrassing.⁸ The East Europeans who were candidates for both NATO and EU membership had to choose. On one side stood Berlin and Paris in opposition to the war. On the other side were Washington, London and their supporters in Madrid and Rome. Eastern Europe opted overwhelmingly for war and US defense secretary Donald Rumsfeld did not hesitate to rub salt in the wounds, playing the “new Europe” against the “old,” leaving France and Germany resentful and isolated.⁹ Habermas and Derrida’s 2003 vision of a distinct “European identity” was directed as much against the East Europeans as it was against the Anglo-Americans. It was core Western Europe that counted. It was left to the European Commission to put a brave face on things. Commission president Romano Prodi was fond of announcing that the fall of the Wall in 1989 and the reunification of Germany and Europe marked not the end of history but a new beginning.¹⁰ Whereas Europe’s history had once meant conflict and penury, now Europe had nothing to fear and the world had nothing to fear from Europe. The EU had overcome both the classic power politics of the nineteenth century and the armed truce of the cold war. As a bringer of stability, prosperity and the rule of law, the EU was realizing Kant’s dream of perpetual peace.

Prodi talked as though the EU would soon emerge as a fully featured state, combining both soft and hard power. But, in fact, the geopolitical configuration of the post–cold war world was more uncertain and ramshackle than that. The EU never developed its own hard-power capabilities. Not only was European military cooperation factious and frowned upon by Washington, but the European states all took the peace dividend. In light of Russia’s weakness, what reason was there not to run down their substantial cold war military establishments? It was this decision that laid the basis for the transatlantic divide on security policy in the 2000s. It also left the East Europeans all the more dependent on the Americans, whose military preponderance grew ever more massive as the new century progressed. At the same time, after the first round of financial assistance in the early 1990s, the United States played no more than a peripheral role in shaping the wider integration of Eastern Europe. On the ground it was the EU that set the pace in erasing the legacy of the Soviet experiment.

II

The incorporation of Eastern Europe into the EU and NATO was an encompassing geopolitical, political and bureaucratic process. But the first mover was not officialdom, but West European business.¹¹ With wages less than one quarter of those prevailing in Germany in the 1990s, the attraction of the highly skilled East European labor force was irresistible. The process of integration was even more dramatic than that taking place among Canada, the United States and Mexico under the NAFTA agreement. Within a decade of the fall of communism, around half of all East European manufacturing capacity was in the hands of European multinationals.¹² East European motor vehicle production, which soon accounted for 15 percent of European output, was 90 percent foreign owned, with VW’s acquisition of Škoda as the emblematic case. Meanwhile, the biggest single foreign investor in Poland in the 1990s was FIAT, followed by Korea’s Daewoo.¹³

If private capital led the way, it was followed by a rising tide of public funding. All over Eastern Europe, highways and public buildings were emblazoned with the blue badge of the EU and its ring of stars. Though the initial levels of spending were quite modest, after 2000 through the Cohesion Fund, the European Regional Development Fund and the EU’s agricultural subsidy schemes, tens of billions of euros flowed from West to East. In the last funding period, 2007–2013, 175 billion euros were earmarked in structural funds for Eastern Europe, 67 billion euros for Poland alone.¹⁴ The Czechs received 26.7 billion euros, and 25.3 billion went to the Hungarians. Across the region, the EU’s money was sufficient to fund between 7 and 17 percent of gross fixed capital formation over a seven-year period. The sums that were poured into the new member states in Eastern Europe by Brussels were comparable in scale to the famous Marshall Plan launched in 1947 to rescue ruined postwar Western Europe. Whereas after World War II it took until the late 1950s before private capital began to flow abundantly across the Atlantic, in the transition economies of Eastern Europe the impact of the EU’s public funding was immediately multiplied by private investment.

Source: Danske Bank Research, “Euro Area: Exposure to the Crisis in Central and Eastern Europe,” February 24, 2009, table 1.

The takeover of Eastern Europe’s industrial base in the 1990s was just the beginning. By the end of 2008 Western-owned banks in the post-Soviet economies had extended $1.3 trillion in credits. These huge figures were not only the result of “foreign loans” but amounted to the wholesale incorporation of the local banking system. Whereas in the eurozone French, Dutch, British and Belgian banks channeled funds into hot spots like Ireland and Spain, in the former Communist world it was Dutch banks like ING, Bavaria’s Bayerische Landesbank, the Austrian Raiffeisen Bank or Italy’s UniCredit that took the lead.

Across Eastern Europe, financial integration went “all the way down.” To an extraordinary extent, foreign currency loans were used to finance mortgages, credit cards and car loans. In Hungary, the most extreme case, between 2003 and 2008, the entire 130 percent increase in household debt was made up of foreign currency credit. What could signify your arrival in the West more clearly and in a more personal way than the fact that your newly privatized home was financed in Swiss francs?

The impact of this simultaneous financial, political and diplomatic incorporation was transformative. In the main cities of Eastern Europe the material standard of living converged rapidly with norms in the West. And it is hardly surprising that this should have made an impression on the less-favored ex-Soviet republics farther to the east. By the early 2000s, many of the former Soviet republics seemed locked in a time warp. As Gorbachev’s foreign minister, Eduard Shevardnadze had been a darling of the West. By the early 2000s his personal regime in Georgia was so riddled with corruption that it could not borrow even from the IMF. Ukraine had suffered almost as badly as Russia in the economic collapse of the 1990s and showed little sign of recovering. The contrast to its Polish neighbor was painful. The “color revolutions” in Georgia and Ukraine in 2003 and 2004 were driven, above all, by the determination not to fall further behind and miss out on the dramatic changes going on farther west.¹⁵ The title of the main Ukrainian protest group PORA translates as “It’s time.” Its symbol was a ticking clock.¹⁶ The post-Soviet laggards had no more time to lose. In Ukraine the revolutionaries of 2004 were careful to preserve a geopolitical balance, opting for neither Russia nor the West. In Georgia things were simpler. Having turfed Shevardnadze out, by 2006 the new Western-backed government in Georgia headed by Mikhail Saakashvili was glorying in its new status as “Top Reformer” accredited by the World Bank. Georgian soldiers were soon on their way to support the coalition in Iraq.¹⁷ Brussels might profess that “the EU does not do geopolitics,” and that slogan suited policy makers in old Europe, particularly Berlin. But to the bevy of new accession states that joined both NATO and the EU between 1999 and 2007 this made little sense. European integration and NATO were born together in the cold war. Their joint eastward expansion since 1989 was the result of the defeat of the Soviet Union. As far as the new accession states were concerned, the historical logic linking the EU to NATO and thus to the United States was undeniable. Western integration promised security and prosperity. But it also harbored risks, both financial and geopolitical.

III

In the financial integration of Eastern Europe as across the emerging market economies, the currency question was paramount. There was no uniformity of currency regime in the former Communist countries.¹⁸ In the Baltics, Latvia opted for a straight peg against the euro managed and defended by the central bank. Lithuania and Estonia opted for currency boards under which the entire domestic monetary system was tied to the stock of euros held by the board. The Poles and the Czechs opted for free floats. Hungary allowed the forint to move within bands. Bulgaria adopted a currency board and Romania a managed float, under which the central bank intervened periodically to guide the movement of the foreign exchange markets within adjustable bands.¹⁹ What they had in common were the optimistic expectation of convergence with the EU and, in due course, eurozone membership. And these hopes were not merely paper dreams. The preemptive adaptation of Eastern Europe economies to EU conditions changed their way of doing business, how markets operated and who owned what. No less significant was the adaptation of their policy-making institutions and their cadres. Thanks to active involvement by the Bank of England and the ECB, the Eastern European states were, by the early twenty-first century, equipped with Westernized central banks, staffed by professional economists.²⁰ No one was more enthusiastic about the prospect of eurozone accession than the central bankers. Alignment with Brussels and Frankfurt not only raised their status. It also shielded them against unwanted domestic political pressure. Soon they would be joining the global elite of central bankers.

The result was that Eastern Europe reproduced on Europe’s doorstep the configuration of overoptimistic expansion that had led to the emerging market crises of the 1990s. Success stories of market reform and privatization, combined with freedom of capital movement and relative stability of exchange rates, led to a huge inward surge of capital. Capital inflow led to upward pressure on exchange rates. All the indicators looked good. But the entire constellation—the booming domestic economy, the appreciating exchange rate, the rising reserves—could all be traced back to a common factor: the huge inward surge of foreign capital. What if that surge reversed? What if there was a sudden stop?

Under top-secret conditions, the IMF ran a simulation exercise in February 2007 role-playing its response to a reversal in Hungary, which was among the most exposed East European economies. So anxious were they to preserve secrecy and avoid a panic that the IMF’s IT department created a separate SimulationMail e-mail system to avoid notes from the game leaking to the outside.²¹ Hungary’s own central bank duplicated the simulation. Its results, it breezily informed a conference at the ECB in the summer of 2007, were reassuring. If there was one note of caution, it was a reminder that 60 percent of Hungary’s banking sector was in the hands of Belgian, Austrian, Italian and German banks. In the event of a crisis, if Budapest was to cope, it would need the closest possible cooperation from its West European counterparts.²²

Hungary’s situation was grossly unbalanced, but the situation in the Baltic states was even more extreme. In early 2008 the IMF noted that Latvia’s economy was overheating so badly that its imports exceeded its exports by an amount equivalent to 20 percent of GDP.^{²³ According to the IMF’s models, its currency was overvalued by between 17 and 37 percent. While China and the United States were in deadlock over their trade imbalances, the IMF’s staff thought it might be less contentious to single out Latvia as a country with an undeniably “fundamental imbalance.” That turned out to be a miscalculation. Any public pronouncement on irrational exuberance in the Baltic was blocked by the Europeans on the IMF board. They wanted to keep the Baltics on track for euro membership and did not want to risk an IMF warning unleashing a chain reaction of uncertainty across Eastern Europe. The Swedes in particular were deeply concerned. Their banks had lent so heavily to Latvia that a crisis could easily spill back across the Baltic. Over the winter of 2007–2008, the Scandinavian representative on the IMF board went so far as to block the dispatch of the IMF delegation to Riga to complete Latvia’s regular Article IV report.}

No one in Europe wanted to burst the bubble. Latvia was enjoying a recovery from the doldrums of the 1990s. In the fall of 2007 its foreign ministry moved into the newly renovated building it had last occupied in the 1930s, when Latvia first enjoyed its independence from czarist Russia.²⁴ As one retrospective commentator noted, there were high hopes that “Latvia would be able to extend its foreign policy presence beyond the transatlantic space and facilitate the development of closer ties between post-Soviet states such as Ukraine, Georgia and Moldova and the EU and NATO. It was estimated that Latvia’s development cooperation budget would grow rapidly, that Latvia would open new embassies in faraway places and that entering Africa in order to help poorer nations to develop was only a matter of time.”²⁵ To say that this was a transformation in the fortunes of tiny Latvia would be an understatement. It was a vision both expansive and fragile. It depended on two crucial conditions—the continuation of Latvia’s feverish economic boom and the acquiescence of its hulking neighbor to the east. Russia had watched as Latvia reclaimed its independence in May 1990. It had watched as Latvia conducted a referendum on EU membership in the autumn of 2003 that overrode the no vote of the ethnic Russian minority, and it had watched as Latvia, along with its Baltic neighbors, joined NATO in April 2004. Would Russia continue to watch as Latvia, and other countries like it, set about rolling back the Soviet-era boundaries of power even farther to the east?

IV

If the 1990s had been terrible for Russia’s economy, the new millennium brought a period of recovery. Vladimir Putin, who was confirmed as president by a landslide election victory in May 2000, will forever claim credit for Russia’s restoration. In fact, the turnaround in Russia’s financial fortunes already had been initiated in 1999 by austere former Communist Yevgeny Primakov, Putin’s political mentor. The collapse in the external value of the ruble jolted Russia’s export industries into life and curbed imports. But the key driver of the recovery was the global boom in oil and other commodities, which began months after Putin took office in the latter half of 2000. From $9.57 per barrel in 1998, the spot price of Urals crude would soar by 2008 to $94 per barrel. It would have taken catastrophic mismanagement for the Russian economy and Russian public finances not to have flourished. The questions were who would benefit from the boom and how would it affect Russia’s relationship with the outside world.

Whereas in the 1990s large parts of Russia’s economy had been privatized, under Putin the energy sector was brought back under the control of the state, which in effect meant the oligarchic group around the president. In the energy sector, the corporate giants Gazprom and Rosneft were the battering ram of state industry. In October 2003 respectable opinion in the West looked on aghast as Mikhail B. Khodorkovsky—who, in the 1990s, had installed himself as the billionaire owner of private oil giant Yukos in a particularly egregious privatization deal—was arrested and imprisoned on charges of tax evasion.²⁶ A year later, Yukos’s main assets were snapped up in a fire sale by a shell company that turned out to be a front for state-owned Rosneft. Meanwhile, Gazprom consolidated its grip on the giant gas industry by buying up Sibneft from Roman Abramovich, who retired out of harm’s way to London to enjoy life at the top of the Premier League as owner of Chelsea FC. In 2006 threats of prosecution forced Anglo-Dutch oil major Shell to sell its valuable Sakhalin assets to Gazprom. In 2007 the TNK-BP joint venture was leveraged out of another promising gas field. Though Rosneft and Gazprom were never merged, together they gave the Russian state a powerful corporate underpinning. By one calculation the share of government-owned firms in oil production in Russia rose from 19 percent in 2004 to 50 percent in 2008.²⁷

With the force of a booming, state-controlled energy business behind them, Putin and his team built on the measures put in place in the 1990s to restore Russia’s finances. Of Russia’s state revenues, just under 50 percent were accounted for by taxes and revenues from oil and gas. The profits would have been even larger if growth in output of oil and gas had not slowed disappointingly after 2005. Nevertheless, as the profits of the oil and gas boom rolled in, household consumption by ordinary Russians surged back to precrisis levels, rising at a rate of 10 percent per annum. By 2007 the percentage of the population below the subsistence minimum had fallen to 14 percent. And this was no longer the feverish, dollarized speculation of old. Prices were stable and were no longer set in dollars. Taxes were paid in rubles. The Russian parliament passed a law imposing fines on public officials who lapsed into the bad old habits of using dollars as a unit of account.²⁸ On one occasion even Putin found himself embarrassingly caught out. From 2003, the Russian Treasury, headed by the technocrat economist Alexei Kudrin, used oil and gas earnings to accumulate a gigantic strategic reserve of international assets. By early 2008 these had reached $550 billion. After China and Japan, Russia was now the third-largest holder of dollar reserves in the world. On Putin’s orders a special staff assembled a national reserve of food and vital raw materials.²⁹ Russia would never again suffer the kind of humiliating crisis that it had lived through in 1998.

Russia could thus seem the very model of a national economic powerhouse, with a huge trade surplus, surging foreign reserves and a strong state. But the paradox of Russia’s position was that its new prosperity was associated not with independence from the world economy but with entanglement with it.³⁰ And this entanglement extended beyond the export of oil and gas. Money was even more liquid and the pipelines connecting the offshore banking system were ready laid. Tens of billions of dollars in oil and gas export earnings never returned to Russia. Russia’s oligarchs behaved like the masters of a 1970s petrostate, harboring their wealth in offshore havens like Cyprus, from where it cycled back to London and its convenient eurodollar accounts. From the early 2000s the pattern was further complicated by a large flow of funds back to Russia. In 2007 this peaked at an annual total of $180.7 billion, of which only $27.8 billion was foreign direct investment (FDI).³¹ The rest flowed through international banks such as Sberbank and VTB into the Russian financial system. To prevent a sharp appreciation, Russia’s central bank, like that of China’s, found itself having to sterilize the dollar inflow by buying it up with freshly minted rubles. Having driven dollars out of domestic circulation, Moscow was now assuming an unfamiliar position as a de facto creditor to the United States.

With the global commodity boom fueling Russia’s resurgence at the same time as West European money flooded eastward into the territory of the former Warsaw Pact, it was as if the two great weather fronts of global capitalism were charging toward each other across Eurasia. Did the contradictory geopolitical consequences of global growth, strengthening both Russia and its former satellites, make conflict inevitable? Certainly not from an economic point of view. The growth of the Polish and Baltic economies and the development of Ukraine, Georgia and Russia did not preclude each other. European exports to Russia flourished and all of Europe relied heavily on Russian gas. The question was whether a shared and interconnected prosperity could be given a common political meaning. Would it be cast as a foundation for a stable and prosperous international order? Or would the uneven but dramatic growth serve as fuel for a new arms race? Would interdependence come to be seen not as productive and efficient but as a source of vulnerability and threat? In the dark years of the 1990s the former Communist economies had experienced a common emergency. Exhaustion and disorder were shared. The common boom, ironically, would prove far more explosive.

Given his background, Putin had far less reason to look favorably to the West than had Boris Yeltsin. But early in his term as president even his critics acknowledge that Putin seemed to be looking to Washington for acceptance.³² After 9/11 Putin overrode the hostile impulses of many Russian nationalists and gave ostentatious backing to the American invasion of Afghanistan. But the rapprochement was one-sided. Under Bush, Washington never took Russia seriously as an ally and refused to treat Moscow’s brutal war in Chechnya as part of the common fight against terrorism and “Islamic extremism.” Rebuffed by Washington, the divisions over the Iraq War provided Russia with leverage. Playing Germans against Americans was a game Putin was familiar with from his old days as a KGB resident in Dresden. Nor was it only Germany and America that were at odds. Germany’s preference for détente with Russia was a source of alienation also between Berlin and the East Europeans. When Germany and Russia signed the first Nord Stream pipeline deal in 2005, enormously increasing the flow of Gazprom’s gas to the West, it was denounced by Poland’s foreign minister as a second coming of the Hitler-Stalin Pact that had sealed Poland’s fate in 1939. When Moscow tweaked Ukraine’s gas prices over the winter of 2005–2006, it only confirmed the Poles’ worst fears. By early 2006 Warsaw and Washington were calling for a new division of NATO to confront Russia on its chosen terrain of energy security.³³

But it wasn’t just gas supplies that were in play. In April 2006 at the meeting of the IMF and the World Bank in Washington, with central bankers Mario Draghi, Ben Bernanke and Jean-Claude Trichet looking on, Putin’s finance minister, Alexei Kudrin, shook hands with the American Treasury secretary. Kudrin had come to announce the repayment of a large tranche of international debt still owed to the Paris Club of creditors from the bad old days of the 1990s. But he had also come to deliver a less friendly message. The dollar, Kudrin declared, was in danger of forfeiting its status as the “universal or absolute reserve currency.”³⁴ It was simply too uncertain in value. “Whether it is the U.S. dollar exchange rate or the U.S. trade balance, it definitely causes concerns with regard to the dollar’s status as a reserve currency.” Eight years on from the humiliation of 1998, when Russia’s finance minister spoke, the markets listened. Kudrin’s words were enough to send the dollar down against the euro by almost half a cent.

On the streets of Moscow the language was more inflammatory. In 2006 Nashi, the Russian nationalist movement, rallied its rent-a-mob following for street demonstrations against dollar hegemony. The lingering attachment of ordinary Russians to the greenback was not just a sign of psychological weakness. “Buying one hundred dollars,” its leaflets informed passersby, “you invest 2,660 rubles in the US economy. This money finances the war in Iraq, this money finances the construction of US nuclear submarines. Various estimates say that the US dollar is worth 15 percent to 20 percent of its face value. The secret of the dollar’s stability is the continued expansion of the dollar zone. . . . [T]his is a financial pyramid based on nothing but simpletons believing in the dollar.”³⁵

In February 2007 President Putin made his first appearance at the prestigious Munich Security Conference. Attended by heads of government and ministers from around the world, the Munich conference is for security policy what Davos is for business and economics. The speech Putin delivered forced into the open the question of the power politics in an age of globalization.³⁶ Looking back at the decades since the end of the cold war, Putin asked: What kind of world organization did the West want to see? It talked of rights and international law, but “today we are witnessing an almost uncontained hyper use of force—military force—in international relations, force that is plunging the world into an abyss of permanent conflicts. . . . One state and, of course, first and foremost the United States, has overstepped its national borders in every way. This is visible in the economic, political, cultural and educational policies it imposes on other nations. Well, who likes this? . . . [O]f course this is extremely dangerous. It results in the fact that no one feels safe. I want to emphasise this—no one feels safe! Because no one can feel that international law is like a stone wall that will protect them. Of course such a policy stimulates an arms race.” Once upon a time America had won an arms race against the Soviet Union on the back of its strong economy. In the new millennium, the United States still commanded huge stockpiles of nuclear weapons and missile systems. America’s military power was undeniable. But in light of contemporary economic developments, any claim to omnipotence was simply unrealistic. “[T]he international landscape is so varied and changes so quickly—changes in light of the dynamic development in a whole number of countries and regions. . . . The combined GDP measured in purchasing power parity of countries such as India and China is already greater than that of the United States. And a similar calculation with the GDP of the BRIC countries—Brazil, Russia, India and China—surpasses the cumulative GDP of the EU. And according to experts this gap will only increase in the future. . . . There is no reason to doubt that the economic potential of the new centres of global economic growth will inevitably be converted into political influence and will strengthen multipolarity.” Under such circumstances, for the West to imagine that a global order could be based on its own organizations—the EU and NATO—rather than the truly comprehensive authority of the UN was either self-deceiving or in profoundly bad faith. Nor could the West reasonably claim that NATO expansion into Eastern Europe had “any relation with the modernisation of the Alliance itself or with ensuring security in Europe,” unless it presumed Russian hostility. How, then, could Moscow not interpret such expansion as a “serious provocation”?

Energy was an object of contention between Europe and Russia, Putin admitted. But what was the answer? Prices, he proposed, should be “determined by the market instead of being the subject of political speculation, economic pressure or blackmail.” With global demand booming, Russia had nothing to fear from the judgment of the market. Its experts were gleefully predicting a future in which oil prices would hit $250 a barrel.³⁷ Gazprom was surging up the global corporate rankings. Within a few years it was projected that it would overtake ExxonMobil as the world’s largest publicly traded company.³⁸ Nor was it reasonable to suggest that Russia was not open for business. Certainly the Russian state had asserted its legitimate national interest, but “26 percent of the oil extraction in Russia is done by foreign capital. Try, try to find me a similar example where Russian business participates extensively in key economic sectors in Western countries. Such examples do not exist!” Russia submitted itself to the judgment of the credit-rating agencies and celebrated the improvement in its standing. It was hoping to gain full membership in the WTO. What Russia would not tolerate, however, and here Putin’s tone harshened, was the repurposing of organizations such as the Organization for Security and Cooperation in Europe (OSCE) “into a vulgar instrument designed to promote the foreign policy interests of one or a group of countries.” Moscow deeply resented the critical commentary on the rigged Russian elections of 2004. It would stand for no repeat of the Western-backed revolutions in Georgia and Ukraine in 2003–2004.³⁹

As one of Russia’s leading commentators, Dmitri Trenin, noted, Putin was driving home the reality of multipolarity: “Until recently, Russia saw itself as a Pluto in the Western solar system, very far from the center but still fundamentally part of it. Now it has left that orbit entirely: Russia’s leaders have given up on becoming part of the West and have started creating their own Moscow-centered system.” Russia was establishing itself as a “major outside player that is neither an eternal foe nor an automatic friend.”⁴⁰ The question of course was who Russia meant to include in its new “solar system.” In particular, what were the implications for the post-Soviet and East European states? What did it mean for a state like Latvia, with its newly redecorated foreign ministry and its ambitions to spread its model of market economics to other former Soviet republics? At Munich in February 2007 the response of the Czech foreign minister, Karel Schwarzenberg, was immediate. “We must thank President Putin,” he remarked facetiously, “who has not only shown concern about the publicity for this conference, but has clearly and convincingly demonstrated why NATO had to enlarge.”⁴¹ Schwarzenberg spoke in the past tense. But the real question was the future. In the face of Putin’s challenge, could the West be content with upholding the status quo in Eastern Europe, or would that imply a tacit acceptance of Putin’s line in the sand? Was the only way for the West to respond to Putin’s challenge to push for even further enlargement of the EU and NATO? The urgency on the part of the smaller ex-Communist states was obvious. Their vulnerability in both security policy and economic terms was only too evident. But how would the big players in the European and transatlantic system—Washington, Berlin and Paris—respond? The question would explode embarrassingly into the open at the NATO summit hosted in Bucharest on April 2–4, 2008.

V

The venue for the meeting was in itself symbolic. Romania, as an eager exponent of the new Europe, had joined NATO in 2004 and the EU in 2007. Romanian soldiers were doing policing duty in the former Yugoslavia, Angola and Iraq. Meanwhile, EU accession triggered a subsidy payment of 19.8 billion euros to Romania’s population of 21 million. It also enabled freedom of movement and a massive migration of Romanians to the West, notably to Italy, where the Romanian population topped 1 million in 2007, triggering local anti-immigrant resentment that the Prodi government struggled to contain.⁴² Meanwhile, at home, Romania’s GDP growth was running at 6 percent, projected to rise to 7 percent in 2008. The Romanians dubbed themselves the “Tigers of the East.”⁴³ There was talk of Romania joining the rich country club of the eurozone as soon as 2012. In Bucharest, its newly renovated capital, the Europe Real Estate Yearbook reported a vacancy rate for prime office space of no more than 0.02 percent.⁴⁴ As US subprime was imploding, international investors like ING Real Estate were snapping up Romanian assets to add to their East European property portfolios.⁴⁵ As host of the NATO summit in April 2008, Bucharest was the perfect stage for the last major effort by George W. Bush to burnish his presidential legacy. And there was no issue more decisive for the future of Russian and Western relations than NATO membership for Georgia and Ukraine.

In February 2008 both Georgia and Ukraine formally applied to be put on a NATO fast-track Membership Action Plan (MAP).⁴⁶ After the Baltics they would be the fourth and fifth Soviet republics to join the Western alliance. Georgia, like the Baltics, was touchy but small. Ukraine was in a different league. With its population of 45 million, its substantial economy, its strategic location on the Black Sea and its historic significance for the Russian Empire, for Ukraine to join the Western coalition would be a terrible blow to Russia, precisely at a moment when Putin had announced his intention to stop the slide. Despite, or perhaps because of, its spectacularly provocative nature, President Bush immediately threw his authority behind the NATO membership bid. Welcoming Ukraine and Georgia into the MAP would send a signal throughout the region, the White House announced. It would make clear to Russia that “these two nations are, and will remain, sovereign and independent states.” It was a proposal that was bound to please the new Europe. Poland’s government was delighted. The fact that Berlin and Paris had reservations was not off-putting. Nor was Bush in any mood to spare their sensibilities. En route to Bucharest in early April, the American president paid a flying visit to Kiev, where he announced: “My stop here should be a clear signal to everybody that I mean what I say: It’s in our interest for Ukraine to join.”⁴⁷ As one US official remarked, the outgoing president was laying “down a marker.”⁴⁸

At the NATO meeting in the Romanian capital the fallout was predictable. Putin, who was attending the joint Russia-NATO session for the first time before handing over the Russian presidency to his associate Dmitry Medvedev, was in no mood to compromise. In February 2008 the West had rubbed salt in the wounds of Russian resentment by extending recognition to an independent Kosovo, overriding the claims of Serbia, which Russia regarded as its client. When, at the NATO meeting, the conversation turned to Ukraine and Georgia, Putin stalked out in protest. This left it to Berlin and Paris to fight the idea of the MAP to a standstill. In so doing they could count on the backing of Italy, Hungary and the Benelux countries against the East European and Scandinavian advocates of NATO expansion. The Americans looked on. As one senior Bush administration official commented to the New York Times: “The debate was mostly among Europeans. . . . It was quite split, but it was split in a good way.”⁴⁹ Condoleezza Rice was less sanguine. The clashes she witnessed between the Germans and the Poles were disturbing. The arguments in Bucharest were, in her words, “one of the most pointed and contentious debates with our allies that I’d ever experienced. In fact, it was the most heated that I saw in my entire time as secretary.”⁵⁰ No formal process of membership application was initiated. But Merkel conceded that the summit should issue a statement endorsing the aspirations of Georgia and Ukraine and boldly declaring, “These countries will become members of NATO.”⁵¹ It was a fudge, and a disastrous one at that. It invited the Russians to ensure that Georgia and Ukraine were never in a fit state to take the next step toward NATO accession. It invited Georgia, Ukraine and their sponsors to force the pace. Ambiguity was a formula for escalation. And both sides responded accordingly.

In May, at the urging of Poland, the EU adopted the idea of an Eastern Partnership for Ukraine as one of the key elements of the new EU foreign policy to be developed under the terms of the Lisbon Treaty.⁵² Despite the opposition they had voiced at Bucharest, there was no counter steer from Berlin or Paris. The EU and NATO stayed locked in step. Meanwhile, Russo-American relations took a sharp turn for the worse. Though he liked to present himself as a modernizer, Putin’s successor as president, Medvedev, continued to steer a hard line. As the financial markets in the United States convulsed in the summer of 2008, dark rumors circulated that Moscow was about to move from verbal attacks on dollar hegemony to concerted action. US Treasury Secretary Paulson had not named his sources, but in the run-up to the Olympics, his Chinese contacts informed him that they “had received a message from the Russians which was, ‘Hey let’s join together and sell Fannie and Freddie securities on the market.’”⁵³ The fragility of America’s mortgage market was about to be turned into a geopolitical weapon. China, which was celebrating its global coming-out party as the host of the Olympic Games, had too much at stake in the US economy to take this suggestion seriously. But over the course of 2008, Russia did unload its portfolio of $100 billion of Fannie Mae and Freddie Mac bonds. As Reuters reported it, the decision was motivated primarily by domestic political concerns.⁵⁴ “The holdings have met hostility from some Russian media and the public, who are wary of risky investments.” By the summer of 2008, one didn’t need to be a Russian nationalist to view American mortgage securities as a bad investment. The GSE were at the heart of the mortgage crisis and were on the point of spectacular failure. Patriotic Russians saw no reason why they should be propping up the United States, which so openly flouted Russia’s national interests. Looking back, Treasury Secretary Paulson ruefully admitted: “[I]t just drove home to me how vulnerable I felt.”⁵⁵

Whereas China refused to participate in a move that would upset the international order, America’s friends in Tbilisi were less cautious. In early August 2008, with Russian encouragement, irregular forces in the rebel province of South Ossetia began shelling positions of the Georgian army.⁵⁶ On August 7, apparently believing that they had Washington’s approval, the Georgian government took the bait. A sudden counterstrike by Georgia’s American-trained army would subdue Ossetia and Abkhazia, settle the outstanding territorial questions and clear the way for a successful NATO membership application. As the awe-inspiring opening ceremony of the Beijing Olympics exploded across Western TV screens, Georgia launched its army and air force into an invasion of South Ossetia. Moscow’s response was devastating. In a matter of days the Russian army crushed Georgia’s undersized forces, inflicting hundreds of casualties. According to Georgian sources, 230,000 civilians were put to flight. After a rapid advance, Russian tanks halted on the Gori-Tbilisi highway, an hour’s drive from the capital.

While President Medvedev announced to his Security Council that August 8, 2008, marked a turning point in the international order and that henceforth the world would have to reckon with Russian power, in the West the reaction was opprobrium.⁵⁷ The presidents of Poland, Ukraine and the Baltics flew into Georgia to express their solidarity. Estonia demanded sanctions against Russia, including the expulsion of Russian students studying at Western universities and travel bans on oligarchs.⁵⁸ Poland called for urgent action to break Gazprom’s grip on Europe’s energy supplies. And Warsaw moved hastily to sign an agreement allowing the deployment of the US missile shield to Poland. But the response was not so unambiguous everywhere. On August 12, 2008, while the United States was preoccupied with Wall Street and the presidential election, President Sarkozy shuttled from Paris to Moscow in the hope of patching up a cease-fire. Though Chancellor Merkel now came out in favor of admitting Georgia to NATO, on September 1 at a special EU summit, any drastic anti-Russian moves were blocked by a united front of France, Germany and Italy. Russia was given three months to withdraw its forces. But Moscow had made its point. In conversation with Western experts as part of the Valdai Discussion Club in Sochi on September 11, Putin remarked that any effort to push Ukraine toward NATO membership would result in severe countermeasures.⁵⁹ Meanwhile, $25 billion in foreign capital fled Russia. But that was no cause for panic. This was not 1998. Moscow had ample reserves to deal with such a minor market mood swing. It was America, not Russia, whose financial system looked to be imploding.

VI

Splits within the transatlantic alliance were not new. The disagreements among Berlin and Paris and the Bush administration over the Iraq War in 2002–2003 had been headline grabbing. But Russia and post-Soviet Europe were far closer to home, far more fundamental to the future of Europe and far more directly linked to the advance of financial and political integration over the previous decades. When added to the incomplete project of the eurozone and the missing political frame for the North Atlantic financial system, the unresolved geopolitics of Europe’s “Eastern Question” completed a trifecta of unanswered political questions that hung over Western power in the summer of 2008.

This was the backdrop of the sixty-third meeting of the UN General Assembly assembled in New York in September 2008. Heedless of the precariously balanced state of the global economy, for the first time since the end of the cold war, Russia and the Western powers had engaged in a proxy war. Russia had announced that it would resist any further extension of Western influence and it had made good on that threat. For its part, the West was disunited. For all the saber rattling in Warsaw and Washington, there was neither the political will nor the resources to back up further eastward expansion. It was against this backdrop that President Sarkozy declared to the UN General Assembly: “Europe does not want war. It does not want a war of civilizations. It does not want a war of religion. It does not want a cold war. . . . The world is no longer a unipolar world with one super-Power, nor is it a bipolar world with the East and the West. It’s a multipolar world now.”⁶⁰ He was, in effect, conceding the point Putin had made eighteen months earlier in Munich. Even if there had been the capacity or the will to further escalate the geopolitical clash, by the fall of 2008 the giant wave of capital that had carried Western political influence deep into Eastern Europe was receding fast. A generation of globalization under the sign of Western power and money had reached its limit. For the immediate future, the sheer shock of the financial crisis would tend to dampen geopolitical tensions. But the damage done by the escalation of 2007–2008 would prove to be long lasting.