The West Should Use Economics to Rein in Russia

Russia's invasion of Georgia has shocked the West and spurred talk about how to respond. The conventional wisdom is that the West can do little to punish Russia. True, western governments have limited leverage, but in economic terms the Russian invasion has already hit it hard, even before western governments lifted a finger. This economic blow shows the West how it can punish Russia's leaders.

On the fateful day of August 8, Russia's stock market plummeted 6.5 percent. It has now fallen 36 percent in the past two months, wiping out $500 billion (€346 billion, £281 billion) of shareholders' capital, almost equal to Russia's international currency reserves of $580 billion. During the week of the invasion, capital outflow reached $16 billion, causing a sudden domestic credit squeeze. Two wealthy Russians have been identified as among the biggest sellers of Gazprom stock. They cannot have been happy with Vladimir Putin, the Russian prime minister. Indeed, Mr. Putin's boasts about Moscow as a new global financial center and the ruble as a coming international reserve currency have become a sad joke.

These substantial losses are likely to last. In a note to investors, UBS, the investment bank, explains that the old paradigm—that investment in Russia carries high political risk—has returned. UBS cut its price targets on Russian companies by an average of 20 percent or a market value of $300 billion.

Russia's economic strength should not be exaggerated. Its gross domestic product has jumped from $200 billion in 1999 to an estimated $1,700 billion this year, yet it accounts for only 2.8 percent of the world's GDP. Despite the Georgian success, Russia's military is underresourced. Official military spending is $48 billion, or 7 percent of US defense spending. With oil and natural gas accounting for 60 percent of its exports, Russia is dependent on world energy prices, which are falling. Its energy production is stagnant because of renationalization and the hostile climate for investors. Corruption is Russia's worst scourge and the state cannot carry out infrastructure investment because of huge kickbacks. With authoritarianism, economic reforms have stalled, but without them high growth rates will not be maintained.

The West faces a choice between sanctions and economic engagement. Trade sanctions would only strengthen the security elite's hold on the economy and reinforce its dictatorship. It would be wrong to oust Russia from the International Monetary Fund or stop its membership of the World Trade Organization, because open markets and international standards will only expose Mr. Putin and his cronies. Instead, the European Union and the United States should impose ethical and legal standards that make it costly for Russia to misbehave, targeting big state companies and top officials, not private citizens or businessmen.

First, the European Union should adopt a common energy policy, imposing the rules of the energy charter—such as transparency, equal investment rights, and third-party access to pipelines—on Russia. A united European Union has bargaining power, as all Russian pipelines outside the former Soviet Union go to Europe.

Second, the European Commission should force Gazprom to unbundle production and transportation to break up its monopolies. Why does the EC pursue antitrust suits against Microsoft but not Gazprom? It would have to divest its pipeline network outside Russia's borders, abandon blatant price discrimination, and end its planned construction of the Nord Stream and South Stream gas pipelines.

Third, the West should investigate Russian top officials and their trading companies for money-laundering.

Fourth, Russia's big state companies habitually woo politicians in other countries. Gerhard Schröder, the former German chancellor, is just Gazprom's most prominent catch. Western ethical rules for contacts with Russian state companies need to be tightened and the European Union should establish American rules for the disclosure of income earned from lobbying. Unethical behavior is best fought with increased transparency.

Finally, if western intelligence agencies possess evidence of any corruption by Mr. Putin or his cronies, they should publish it. Nothing would undermine him more in Russian eyes than verified facts about corruption. Russia and its leaders are quite vulnerable, but to be effective the West needs to unite.