While the battle for Kyiv rages, the economic war between Russia and the nations of the West has barely begun.

The US, the EU and their allies are concentrating their economic attacks on Russia’s financial system while exempting the energy sector.

Russian President Vladimir Putin’s initial response to what he termed ‘illegitimate Western sanctions’ of putting nuclear forces on high alert effectively threatens world war.

If he pulls back from that brink, Putin is likely to exploit European dependence on Russian energy supplies to retaliate.

The financial and energy battlegrounds carry the most obvious risks for the global economy, but other, less obvious, economic threats lurk in the shadows, among them the dependence of microchip manufacturers on rare gasses sourced from Ukraine.

After several days of prevarication, Western powers announced that sanctions would be applied against the Russian central bank and that ‘selected’ Russian banks would be ejected from SWIFT, the secure global financial communications network used by the world’s banks for their international transactions.

The decision to sanction the central bank is stunning: on the eve of its invasion, Russia held US$643 billion in international reserves, the fourth largest in the world behind China, Japan and Switzerland.

Credit Suisse analyst Zoltan Pozsar told Bloomberg that about US$300 billion of that was held offshore. He estimates that about half is held in US dollars. There would also be a large holding of euros.

The joint statement on sanctions by the US, the EU, the UK, France, Germany, Italy and Canada did not detail how comprehensive the restrictions on dealing with the Russian central bank would be but said they would be designed to ‘prevent the Russian Central Bank from deploying its international reserves in ways that undermine the impact of our sanctions’.

When the Trump administration sanctioned the Iranian central bank in 2019, it placed it on the ‘specially designated nationals’ list, which meant that not only was the central bank banned from dealing in US dollars, but so too was any organisation around the world that transacted with it.

The Credit Suisse analyst said the freezing of Russian funds held offshore would have a destabilising impact on world financial markets, pushing the margin between borrowing and lending rates higher.

It will make it difficult for Russia to defend its currency, which could suffer a sharp depreciation, pushing up prices and forcing interest rate increases.

Russia would likely characterise moves to freeze its foreign exchange reserves as theft—the country sold down its holdings of US Treasury bonds in 2018 precisely to avoid such sequestration.

China, which still holds a third of its US$3.3 trillion foreign exchange reserves in US Treasury bonds, would be shocked by any freezing of Russia’s reserves. The financial ructions that would be caused by the Chinese quitting their Treasury bond holdings have often been the topic of speculation. Any such move would come at great cost to China, whose interest is in a stable global economy, but Chinese authorities would doubtless be considering their options.

If the Russian central bank is put on the US specially designated nationals list, it would be difficult for China to provide financial assistance because it would risk being sanctioned. China largely abided by US sanctions on Iran.

The G7 leaders didn’t specify which Russian banks would be ejected from the SWIFT network; however, it’s assumed they won’t include the institutions that European nations need in order to pay for their Russian oil and gas imports.

A note from the German statistics bureau last week estimated that Germany alone spent €19 billion ($A30 billion) on Russian oil and gas last year.

US President Joe Biden said the toughened sanctions package was designed to enable energy payments to continue. ‘We are closely monitoring energy supplies for any disruption,’ he said.

There are echoes here of the early 1970s, when a burst of inflation, which started with excessively easy monetary policy, was pushed far higher by the 1973 OPEC oil embargo that followed the Yom Kippur War.

Facing congressional elections later this year, the Biden administration desperately wants to avoid an energy crisis. However, provoking such a crisis is Russia’s most obvious means of retaliation for Western sanctions.

When Germany cancelled the certification of the huge Nord Stream 2 gas pipeline from Russia last week, former Russian president and chair of the Russian Security Council Dmitry Medvedev tweeted, ‘Welcome to the new world, in which Europeans will soon pay €2,000 euros per 1,000 cubic meters of natural gas!’

In fact, Europeans were paying €2,200 euros, or double the rate of the previous week, by last Tuesday as markets conjured the implications of losing a third of the EU’s gas supplies. The oil price spiked to US$106 a barrel, the highest level in eight years.

Russia has leverage because energy markets are already tight—all fossil fuels are in short supply because investment in the energy sector has been so weak over the past two years amid the pandemic and concern about climate-change abatement policies. It would not take much of a cut from Russia, which is the world’s third biggest oil producer and the largest exporter of gas, to send oil and gas prices spiralling higher. Markets are already talking about US$150 a barrel for oil.

The last time prices approached that level was in 2008 as Russia was preparing its invasion of Georgia.

Until early this year, many central banks, including the Reserve Bank of Australia, were viewing rising inflationary pressure as a ‘transitory’ response to supply pressures, but an energy crisis would cement it, raising the risk of 1970s-style ‘stagflation’ with both rising unemployment and rising prices.

While instability in financial and energy markets is the most obvious global economic risk from the crisis, there will be other disruptions. Russia is the biggest source of wheat exports globally, while Ukraine ranks fifth, just ahead of Australia. If Russia gains control of Ukraine, it will control up to 30% of global wheat exports. Like many commodities, wheat was already in short supply with fast rising prices before Russia invaded. It’s not clear whether the Western nations will exempt wheat sales from their sanctions, as they have with oil and gas.

Russia is also an important exporter of aluminium, nickel, titanium and palladium—all metals with crucial high-tech applications—and, along with Ukraine, is a major supplier of gasses used in the manufacture of microchips.

While neither Russia nor Ukraine is deeply integrated into global value chains in the way major Western and Asian economies are, both are advanced nations with links to the rest of the world that can only be broken at a cost to both themselves and the global economy.

The world is not enduring a ‘Ukraine crisis’, but rather a Russia crisis. So said Germany’s new foreign minister, Annalena Baerbock, at the most recent Munich Security Conference, which was dominated by the situation in eastern Europe.

In fact, Russia’s crisis goes even deeper than Baerbock probably meant. We are witnessing the latest instalment in a longer process. Russia is trying to decide whether it is a nation-state or an aspiring empire, and until that fundamental question is resolved, conflicts like the one over Ukraine will continue in various forms.

On paper, the Soviet Union was a multinational federation of republics. In reality, Russians were solidly in command of a tightly controlled regime headed by the Communist Party. One reason for the Soviet collapse was that many of its constituent republics had become aspiring nation-states, or, as with the Baltic republics, sought to recover their independence. The single most important factor was Ukraine’s December 1991 referendum, in which an overwhelming majority voted for independence. But Russian President Boris Yeltsin’s behind-the-scenes efforts to assert Russia’s own sovereignty were also important.

At the time, Soviet President Mikhail Gorbachev was still struggling to preserve certain state structures, and he responded with hostility to the three Baltic republics’ expressed aspirations. But he was undercut by Yeltsin, who had recognised the independence of Estonia, Latvia and Lithuania even before the Ukrainian referendum.

That was the start of today’s Russia crisis, fuelled by the conflict between building a modern state and economy, on the one hand, and indulging imperial nostalgia, on the other. As a result, Russia’s economic and political modernisation has been hampered, and its neighbours’ security has been in doubt.

The best way for Russia to guarantee its own security would be to foster friendly relations with its neighbours, so that they can feel secure and stable themselves. But it has not done that, and now a growing number of Ukrainians want to join NATO. Unrealistic as that seems, they recognise that their own national aspirations are directly threatened by Russian imperial revanchism.

In an infamous essay published last July, Russian President Vladimir Putin articulated his vision of a great Slavic empire, harking back to 19-century tsarist rule, rather than to the Soviet Union. Sensing an opportunity to promote that vision, he engineered the current crisis.

But Putin’s machinations are nothing new. In 2014, he annexed Crimea and launched an incursion into eastern Ukraine’s Donbas region because he wanted to prevent Ukraine from seeking closer ties with the European Union. Even though that would not have impaired Ukrainian cooperation with Russia or threatened Russian security, such developments ran counter to Putin’s quasi-imperialist dream.

Putin took his fantasy to a new extreme in his recent speech announcing that Russia would recognise the independence of the two breakaway Donbas regions that it has backed since 2014. Putin openly questioned the existence of a Ukrainian nation and insisted that Ukraine is a ‘historically Russian land’. Although there was a Kyivan Rus state long before any Russia had appeared, Putin attributes the emergence of a Ukrainian state to Lenin and the Bolsheviks.

The irony of this history-driven strategy is that if one were to survey the Europe of a thousand years ago, there would be no Russia to speak of. Rudimentary Slavic state structures had begun to emerge in the region stretching from Novgorod to Kyiv, along the old trading routes between the Baltic and Black Seas. But Constantinople was the imperial metropole. What we now call Russia wouldn’t take form until centuries later, following a gradual military expansion in different directions.

To ground imperial ambitions in old national myths is as dangerous in Russia’s case as it is everywhere else. Europe can enjoy peace only if all the borders and boundaries that history has produced (usually through bloodshed) are fully respected. Russia ought to have learned to live harmoniously with its neighbours by now. Following the Sino-Soviet split, the Soviet Union had vast military forces stationed along its border with China, and violent conflict erupted for seven months in 1969. But the two countries de-escalated, and now both are better off for it.

To be sure, the road to establishing the same kind of relationship between Russia and Ukraine is much longer. Putin’s behaviour has understandably left Ukrainians sceptical of Russia, if not hostile towards it. Unless Russia refocuses on building its future solely within its own borders, the region will remain under a cloud of insecurity, ultimately to Russia’s detriment.

I still remember a conversation I had decades ago with former German Chancellor Helmut Kohl, a statesman well versed in European history. Discussing Luxembourg, he noted that Germany was secure because even its smallest neighbour saw it as a close friend. Germany has come to terms with its past. Russia has not. Until it does, all of Europe, but especially Russia itself, will continue to suffer.

Empires never fall quietly, and defeated great powers always develop revanchist aspirations. That was the case for Germany after World War I: a humiliating peace agreement and the offer of former German territories to the country’s weaker neighbours helped to lay the groundwork for the awful revisionist adventures of World War II. And it’s the case for Russia today.

In 2005, Russian President Vladimir Putin called the Soviet Union’s collapse ‘the greatest geopolitical catastrophe of the [20th] century’. So, under the pretext of protecting ethnic Russian minorities outside Russia’s borders, he’s attempting to reverse it.

Ultimately, Putin seeks a return to the post-war order, with a new Yalta-style agreement enshrining Russia’s recovery of the Soviet Union’s sphere of influence. In his view, this approach is essential to ‘peaceful development’. Through its heroic victory over fascism—which the West seeks to diminish with its ‘historical revisionism’—Russia earned its place in the top echelon of the global power hierarchy.

Of course, in practice, Russia already maintains a sphere of influence. It does so, for example, by sustaining ‘frozen’ conflicts in former Soviet republics, from the clash between Armenia and Azerbaijan over Nagorno-Karabakh to the dispute over Transnistria, an unrecognised breakaway region of Moldova.

Russia also intervenes to help Kremlin-friendly governments quell domestic dissent, such as in Belarus and Kazakhstan. And it has brought most of the former Soviet republics into the Eurasian Economic Union and the Collective Security Treaty Organization, under which it keeps military bases in Armenia and Kyrgyzstan. Tajikistan is also home to Russian military bases, as are Abkhazia and South Ossetia, secessionist regions of Georgia that Russia recognised as independent sovereign states after its 2008 invasion, which effectively ended Georgia’s bid for NATO membership.

But a prized piece of Russia’s sphere of influence might be slipping away. The focus of the current standoff between Russia and the West over Ukraine reflects the country’s size and strategic value. But there’s also a historical and emotional component to Putin’s commitment to keeping the country in the Russian fold.

As Putin told a boisterous crowd after annexing Crimea in 2014, Ukraine represents the Orthodox Christian kingdom of Rus, the basis of Russian civilisation. Crimea has ‘always been an integral part of Russia in the hearts and minds of people,’ he said, and Ukraine’s capital, Kyiv, is ‘the mother of Russian cities’. More recently, he has repeated his longstanding claim that ‘Ukraine is not even a country’; the ‘greater part’ of its territory ‘was given to us’.

Whether Putin’s version of history is accurate is immaterial. There is hardly a country that hasn’t reinvented the past to serve the needs of the present. What matters is his commitment to the goals he is pursuing—and the context in which he is pursuing them.

Putin is clearly willing to go to great lengths to keep Ukraine out of NATO. What he may not have accounted for, however, is that the stakes are also high for the United States, whose global reputation has been severely eroded recently, not least by the chaotic withdrawal from Afghanistan and the country’s subsequent takeover by the Taliban.

Allowing Russia to make a mockery of the 1994 Budapest Memorandum (to which Russia is a signatory) guaranteeing Ukraine’s territorial integrity would upend the European security system and deal a death blow to America’s global standing. Why would South Korea, Taiwan or Japan trust American security guarantees against China’s designs in East Asia? Why would Iran sign a new nuclear agreement with the US?

Although US President Joe Biden has ruled out direct military intervention, a full-scale invasion—or even a ‘minor’ one aimed, say, at creating a territorial corridor between Russia and Crimea by annexing land in eastern Ukraine—could well trigger a resolute American response. Even if it didn’t, and Russia managed to defeat Ukraine’s military—the third largest in Europe—pacifying the country wouldn’t be easy. An invasion of Ukraine could turn out to be as damaging for Russia today as the invasion of Afghanistan was for the Soviet Union in the 1980s.

Putin might have realised this by now, and thus may welcome a face-saving diplomatic solution to the crisis he has created. But the standoff will nonetheless have a lasting impact. After all, Putin has already reaffirmed that Russia is a revisionist power capable of disrupting the security arrangements Europe built in the aftermath of the Cold War.

In particular, the crisis has exposed the divisions in the transatlantic alliance. Plagued by a ‘double addiction’ to US security guarantees and Russian gas, and weighed down by the ghosts of its history, Germany has avoided a commitment to a NATO response. In fact, most European countries were unhappy with the sanctions imposed on Russia after the annexation of Crimea, and still disagree with the US about what should trigger new sanctions. And none of America’s European allies is eager for Ukraine to join NATO anytime soon.

The origin of Russia’s resentment towards NATO enlargement can be traced to February 1990, when US Secretary of State James Baker assured Soviet leader Mikhail Gorbachev that NATO would expand ‘not one inch eastward’. In September of that year, as part of the Two Plus Four Agreement that permitted German reunification, the Soviets consented only to NATO membership for Germany. Robert Gates, who became CIA director the following year, admitted that the Russians were ‘misled’. As a result, while Leningrad was almost 2,000 kilometres from NATO’s eastern edge at the end of the Cold War, St Petersburg is now less than 100 miles away.

When the current showdown ends, the US should reconsider plans for NATO’s expansion. As George Kennan, the architect of America’s Cold War ‘containment’ strategy, predicted in 1997, NATO’s eastward expansion inflamed Russia’s ‘nationalistic, anti‐Western and militaristic tendencies’; restored ‘the atmosphere of the Cold War to East–West relations’; and drove ‘Russian foreign policy in directions decidedly not to [the West’s] liking’. This, he believed, could turn out to be ‘the most fateful error of American policy in the entire post–Cold War era’.

The US needs to take Russia more seriously. Dismissing the country as a ‘regional power’, as President Barack Obama did, is dangerously counterproductive. For all its weaknesses, Russia is a power to be reckoned with, and its legitimate concerns must be respected.