August 1914: a global financial crisis caused by the outbreak of World War I resulted in the Bank of England’s losing two-thirds of its gold reserves in less than a week, placing at risk London’s pre-eminence as the center of global finance.
One innovative way to fund the Ukraine war: Use Russia’s foreign exchange reserves as collateral to raise private sector debt.
To prevent a financial collapse, the U.K. government tapped the economist John Maynard Keynes, who proposed a series of unorthodox steps that were not well aligned with conventional wisdom, let alone the preferences of the bankers who populated the City of London.
Keynes recommended that U.K. treasury flood the zone with liquidity via paper money while retaining a nominal link between gold and the pound.
As unorthodox as the advice was at the time, the U.K. governing authority accepted it, resulting in widespread acceptance of the paper currency, rising bank deposits and stabilization at the central bank that could now meet foreign redemption requests for gold without worrying about such domestic demand.
Keynes’s innovative plan to reflate the financial system through the issuing of new paper, while using gold for foreign payments, prevented a financial collapse and created the conditions for wartime funding.
In turn, the U.K. was the only economic power that maintained its foreign gold commitments following the financial crisis.
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Keynes’s innovation would be the first of many he put forward—ending the barbarous relic of the gold standard would be one—that transformed the economic, political and financial framework of Western capitalism.
The ending of the first financial crisis of World War I (there would be another in 1916-17) effectively represented the mobilization of the U.K.’s greatest asset—its access to deep pools of private capital to stem Germany’s attempt to change Europe’s balance of power.
That policy shift permitted the U.K. to retain its status as the world’s pre-eminent financial center and preserve sterling’s role in global finance and trade.
It was just one example of the challenge that wartime finance poses for policymakers and economists like Keynes.
Today, policymakers are facing a new challenge: How to finance wartime operations and reconstruction in Ukraine.
Interest, power and wartime finance
More than two years into the outbreak of war, the need for capital, and materiel, to battle Russian forces have not abided.
The European Union recently committed $54 billion for the war effort, which brings its total funding to approximately $96 billion over the first two years of the war. To put that in perspective the E.U. spent approximately $295 billion on defense in 2023. If one includes expected defense spending by the U.K. this year, the non-U.S. NATO members will spend $380 billion on defense this year.
The United States, for its part, has committed roughly $75 billion in aid to Ukraine. But the bipartisan support for such aid has frayed recently, and a proposed $60 billion in additional funding, part of a broader measure pending in Congress, is now tied up.
While approximately six out of every 10 dollars of that funding in the special supplemental legislation would go directly to U.S. defense companies—and would considerably aid efforts around the reinvigoration of such industrial capacity—and add roughly 0.5% of gross domestic product to the domestic economy over the next few years, that funding remains controversial at best and is part of the stalemate.
This stalemate over funding has led to growing calls for the confiscation of the $300 billion in Russian foreign exchange reserves that are frozen because of Western sanctions. Other innovative ideas have been floated as well, including tapping interest earned on those reserves.
Much of the discussion seems to come back to that $300 billion in Russian reserves sitting on the balance sheets of Western central banks, and whether it’s legal to confiscate that money.
As Keynes showed, financial innovation and wartime finance is neither new nor novel. The Ukraine quandary is just the latest to test best minds over how to mobilize the deep pools of capital around the world to support Ukraine’s fight. So we ask: What would Keynes do?
The logic of wartime financial innovation
Belgium was the first to float the idea of using Russian reserves as collateral to finance wartime operations in Ukraine.
In our estimation, Keynes would have recognized the idea as efficient and appropriate, and in keeping with the rules-based economic order that has governed global economics for the past several decades.
Here’s how it would work: Russia’s foreign exchange reserves would be used as collateral to raise private sector debt through the placing of such funds in an escrow account.
In the most basic form, the reserves would become collateral for zero-interest bonds that have no coupon. Purchasers would buy them at a discounted value of, say, $15,000 for a 20-year note. At maturity, the issuer would pay the purchaser, say, $30,000 to compensate for the duration risk of the note.
This makes sense on a number of levels. First, it provides immediate and much-needed financing for the Ukrainians while simultaneously providing an incentive for the Russians to end the war in hopes of regaining access to that $300 billion.
Second, because most of any funding would flow through American and European manufacturing centers, it would help revive the Western defense industrial base and send a compelling message of deterrence to China, Iran and Russia. Just as important, it would provide a timely boost to the European economy in general and the German economy in particular, which have been sagging in the face of global competition and the rise of industrial policy among the advanced economies.
Third, it would avoid a costly and lengthy delay that would almost certainly ensue should the Western allies attempt to confiscate the capital currently frozen under existing sanctions.
Finally, by not confiscating such capital, the U.S. and European allies would not jeopardize the reserve status of the dollar and put the euro at risk. Assuming that Canada, the U.K., Japan and Australia would all participate in such an innovative funding policy, the respective six currencies represent approximately 96% of total currency reserves across the international economy.
By operationalizing its deep capital markets and by taking care to avoid confiscating Russian reserves, the allies could create the conditions for the pursuit of their national interest while not sacrificing their reputation as capital centers governed by the rule of law and transparency.
In short, the NATO countries bringing their financial power to bear would signal to adversaries that they will not hesitate to use a key weapon in defense of the rules-based global order.
Reparations and confiscation: Lessons from World War I
Reparations, which are legally binding levies on countries to pay the war costs of another party, are nothing new.
In 1919, the Treaty of Versailles placed heavy reparations primarily on Germany to compensate the Allies for some of their war costs, that prominently featured property seizures.
In 2003, the U.S. seized $1.4 billion in Iraqi assets that had been frozen since the first Gulf War in 1991 to pay for humanitarian aid and reconstruction following the invasion of Iraq in 2003.
According to a 2020 paper in the Journal of the History of International Law. wartime and postwar expropriation had long been used in Europe, with property seizures explicitly built into the punishing surrender of Germany to the Allies.
The advantage of seizing property was that it was the only way to wage war that was also a way of paying for it, the paper said.
But there was an ulterior motive as well in the Treaty of Versailles.
The Allies of World War I used the aftermath of the war to degrade Germany’s international economic presence. This was done primarily through the sequestration and expropriation of German assets abroad. The result became one of the greatest postwar asset transfers in modern history.
The United States, which had been reluctant to join the Allies in part because of Germany’s pre-war investment in the U.S. economy, became the prime beneficiary of those postwar expropriations.
There was just one problem for the Allies. The widespread wartime confiscation of private property went against the grain of international economic law as it had been developing for the previous six decades.
Keynes saw other problems as well. He saw the treaty as meaning that the whole of German property over a large part of the world could be expropriated and retained permanently, with no timetable for ending the expropriations and with no agreed-upon facility for transferring the funds.
Keynes believed the consequences of the treaty would be catastrophic—a peace that had the intention of crushing the losing side.
Keynes wrote that the treaty included “no provisions for the economic rehabilitation of Europe” and that the negotiators had little understanding that a lasting postwar European peace required a sound economic foundation.
As Keynes predicted, the ongoing disgorgement of Germany led to the economic collapse in Europe.
That collapse resulted in German hyperinflation, the Depression, the rise of authoritarian rule, the killing of six million Jews, and World War II.
If there are reparations or outright confiscation of capital for the loss of life in Ukraine put on Russia, they should be administered by the World Court, with international law determining the legality of any confiscation.
The Marshall Plan and the end of retribution
Before World War II had ended, Keynes had established the modern political and legal framework for international economic and monetary order.
He was instrumental in the formulation of the foreign exchange market and the universality of economic growth through the creation of the International Monetary Fund and World Bank.
Keynes’s macroeconomic formulations laid the foundation for the Marshall Plan in 1948 that rescued Germany and Europe from famine and prevented the spread of communism into Western Europe.
The several years that followed World War II found Europe staring at a catastrophe even greater than what fostered the rise of the Nazis. Europe lacked everything from wheat to coal to steel to democratic institutions.
Keynes saw aid from the U.S. as necessary. Europe could not do it alone and neither could the private sector.
To George Marshall’s thinking, economic health was a prerequisite to political stability and Western Europe could achieve neither without U.S. assistance.
Most important, following Keynes’s intellectual leadership the Allies avoided the all-too-human instinct to punish the vanquished through confiscation and reparations. The result has been the creation of a democratic and market-driven economy of Germany (and Japan) and what would become the economies of the European Union, second only to the United States in terms of private economic output.
Confiscation, reconstruction and lessons learned
The argument for the confiscation of Russian reserves is easy to understand. Russia invaded Ukraine and is responsible for the damages that illegal action caused. But legal constraints and history both imply that would be difficult at best and almost impossible at worst, and could conceivably cause bigger problems between Russia, Ukraine and the West going forward.
As of December, the European Commission estimated that the total cost of reconstruction and recovery in Ukraine will be $486 billion (€452.8 billion) over the next decade. That would be more than two-and-a-half times Ukraine’s projected economic output for this year.
At that the start of 2022, Russia’s central bank held around $207 billion in euro assets, $67 billion in U.S. dollar assets and $37 billion in British pound assets. It also had holdings comprising $36 billion of Japanese yen, $19 billion in Canadian dollars, $6 billion in Australian dollars and $1.8 billion in Singapore dollars. Its Swiss franc holdings were about $1 billion.
Russia’s central bank said these assets were invested mainly in foreign securities, bank deposits and accounts used to facilitate foreign exchange and trade transactions.
There is a moral basis for compensating Ukraine for its losses. But is there a legal basis for confiscating its assets?
In our view, it is unrealistic to think that Russia will agree to pay for its violation of international law, whether or not there is a negotiated end to the violence.
While the evolution of international law suggests that we are a century beyond the practice of warfare and retribution, a fragmented international community lacks the ability to consistently enforce international obligations and judgments.
What would Keynes do?
In our estimation, Keynes would approve of the creative proposal to use Russian reserves to fund wartime operations by Ukraine while still retaining the rule of law that underscores the capital markets in the West.
Moreover, Keynes would almost certainly be against the outright confiscation of Russian reserves or significant wartime reparations designed to cripple the Russian postwar economy.
One of the major lessons learned during the 20th century was that the unrestricted confiscation of the spoils of war and punitive reparations ended with the disastrous outcome of the Treaty of Versailles and everything that followed.
Keynes vehemently opposed the harsh conditions imposed on Germany after World War I and correctly predicted the revanchism by Germany that followed to the point that for a time harmed his standing in the U.K.
The steps that the Western allies take to aid Ukraine will shape both the dimensions of the conflict and its aftermath. And, in turn, the deployment of its financial firepower to finance those operations represents the next step in the evolution of the economic dimensions of U.S. grand strategy in our new multipolar era.
