Why Europe Shies from Ukraine Showdown

The crisis over Ukraine and Crimea threatens to touch off a new version of the Cold War's "mutual assured destruction" - or MAD - not from nuclear warfare but from the economic damage that the two sides, particularly Russia and the European Union, could inflict on each other, with fallout reaching the United States.

Though the EU and the U.S. may have started this crisis by trying to pull Ukraine away from Russia and into the European fold - maneuvers that led to a violent coup d'etat in Kiev last month - Russian President Vladimir Putin countered the West's moves by annexing a willing Crimea and asserting Russia's right to protect ethnic Russians in Ukraine's east and south.

That prompted the West to impose targeted sanctions against some prominent Russians, to oust Russia from the G-8 meeting of industrialized nations, and to threaten more severe sanctions that would damage the Russian economy if Putin won't back down. President Barack Obama added insult to the injury on Tuesday by dismissing Russia as "a regional power."But Putin finds himself with a strategic advantage in that Europe is struggling to emerge from a long and painful recession that has divided the Continent between the EU's stronger and weaker economies. Europe's fragile recovery would likely suffer a crushing blow if the economic warfare with Russia escalates.

A new economic downturn would be particularly devastating to the so-called "periphery countries" - such as Portugal, Spain, Italy, Greece and Cyprus - which still suffer from painful levels of unemployment and which could experience devastating political upheavals if the EU goes into another recessionary dip.

It is those countries and others in southern and eastern Europe that are putting up the most resistance to a determined campaign to punish Russia. Portugal and Spain are the least exposed to direct Russian ties, but their economies might not survive another external shock.

That's why European leaders, in general, decided to take a more cautious approach than the U.S. in retaliating against Russia for annexing Crimea. The broadened blacklist of targeted individuals is still shy of seeking a direct showdown with Russia.

But the EU did sign the association agreement with Ukraine's interim government which took power after last month's coup ousted elected President Viktor Yanukovych, who had rebuffed the EU's offer as too harsh and instead accepted a more generous aid package of $15 billion from Russia.

Greater Risks

The EU's reluctance to join Obama in an escalation of the tit-for-tat sanctions war with Russia reflects the reality that U.S. bilateral trade with Russia is less than a tenth of EU's trade. While it's hard to quantify the exact impact of an escalation on Europe's fragile recovery, it's fair to say that the closer a country is to Russia the more severe the likely consequences, especially if Russia's energy shipments are disrupted.

Before the Ukraine crisis erupted in February, the EU Commission was getting slightly more optimistic about the Continent's economic growth, raising the 2014 outlook from 1.1 percent to 1.2 percent and the 2015 outlook from 1.7 percent to 1.8 percent. But those pallid numbers themselves explain why the EU is nervous. It wouldn't take much to cause a new contraction and set off a new wave of political unrest.

According to several bank research notes, the GDP impact of a sustained crisis with Russia could be a decline of about 1.5 percent in the Eurozone, but nearly a 3 percent hit for Poland. Particular harm would be inflicted on the weakened banking sectors of the emerging European economies. Even stronger economies, like Germany's, could feel some effect, a possible 0.5 percent drop.

A 1.5 percent economic slowdown for the Eurozone could prove intolerable for European populations that have already felt severe pain from the Wall Street crash of 2008 and the austerity that was prescribed by Europe's central bank and some political leaders, including Germany's Chancellor Angela Merkel.

Given the likely economic damage from a prolonged standoff with Russia, it is hard to imagine that the EU's leadership could sustain the political support necessary, especially given the murky circumstances surrounding the Ukrainian uprising and the clear desire of Crimean voters, expressed in a referendum, to abandon Ukraine's failing state and to rejoin Russia.

The five years of recession have already caused many European leaders to be voted out of office and for the EU's unity to be strained by the uneven impact of austerity across the Continent. There appears to be no appetite for more belt-tightening to make some geopolitical point.

Instead, the European bloc is struggling to jump start an economic recovery and build a more solid institutional framework for sustained growth, such as a banking union. Furthermore, harsh economic sanctions - severe enough to deter Russia - would require unanimity from the 28-member European Union, a unity that is lacking.

Though Great Britain leads a small group of European countries demanding a more robust response to the annexation of Crimea, most southern and central European countries prefer to defuse the crisis. In the middle of both is Germany, which stands to lose a lot from an economic war but also sees itself as the de facto leader of Europe.

Russia's Stake

While it's true that Russia's economy would likely suffer exponentially more in terms of percentage damage from a sanctions and trade war with the West, Russia's energy exports would eventually find new markets in energy-hungry countries such as India and China.

Plus, the issue of Ukraine and Crimea has a much greater emotional pull on the Russian population than on the rest of Europe, giving Putin more political leeway than his European counterparts have.

Still, Russia is not in a great position to engage in a protracted economic war. Its economy is small, the size of Italy's, and it's very dependent on Europe, its most important trading partner. Europe accounts for 75 percent of Russia's foreign investment stocks.

But Russia is vital to global oil and gas supplies, and as such wields tremendous power. About a third of Europe's oil and even more of its natural gas comes from Russia. While it's true that Russia would not survive without its energy industry, neither could Europe function without Russia's critical oil and gas supply.

Even a small economic conflict could have serious repercussions. Supply disruptions, regardless if it's over sanctions against Russia or Russian gas cutoffs, would cause energy prices to rise. Gas shortfalls would especially affect Eastern Europe and perhaps Italy.

The West also would find it hard to isolate Russia's economy with sanctions given its land mass and its relations with other expanding economies, such as India and China. Europe and Russia additionally share significant economic interests beyond energy, especially in terms of investment and joint ventures that span the globe.

Business leaders of both sides are already lobbying for more caution, lest their mutual investments be threatened, causing collateral damage to countries far from the front lines of Russia and Ukraine.

One of the Kremlin's strongest weapons in an economic war would be its ability to destabilize Ukraine's economy, where European countries also have significant interests. Europe will need to help Kiev's near-bankrupt government in any event, but the situation would get even costlier if Ukraine has to deal with the instability that Russia can cause, particularly by turning off Ukraine's natural gas supplies if back debts aren't paid.

With Russia also ending its gas discounts to Ukraine, the interim government may have to grapple with prices doubling. Russia entrenched itself in Ukraine precisely to make the cost of any switching sides to Europe very costly. Putin knows that. And he is wagering that even though Russia is more exposed economically, Europe is less prepared to weather the economic storm or to pay the staggering bill for rebuilding Ukraine's economy.

So, most observers expect that the EU will wait for Russia's next move before entering what some call "phase three" of the crisis - the first two being the original sanctions list plus the expanded one. Though the West has refused to recognize the legality of Crimea's secession from Ukraine and its annexation by Russia, the sanctions war is only likely to escalate if Russia intervenes in Ukraine's east and south to protect ethnic Russians.

To avert that possibility, the interim government in Kiev has softened its initial aggressiveness in asserting firm control over the eastern and southern regions which were the political strongholds of ousted President Yanukovych. A key question, however, is whether the Kiev regime can rein in the armed far-right militias that spearheaded the violent overthrow of Yanukovych.

If the civil violence in Ukraine worsens and if Russia intervenes militarily, the result would likely be more painful commercial, economic and migratory sanctions, which the EU is calculating would be more damaging to Russia than to Europe. But the consequences would be so serious that EU leaders agreed to economically compensate the most affected countries.

The reality is that Russia and Europe are mutually dependent, though each side may believe it has the upper hand. But the fundamental question boils down to which side can muster the most support at home for enduring the economic pain.

And, therein lies Europe's weakness. In pressing for an association agreement with Yanukovych's government last year and then quickly recognizing the coup regime that ousted him last month, the EU clearly miscalculated the Kremlin's resolve over Ukraine. But Putin may be underestimating Europe's vulnerability at a moment of economic weakness.

Still, considering Russia's resolve throughout history, specifically when it comes to Crimea, which has been part of Russia since the 1700s, and Russia's willingness to sacrifice economic benefits for its strategic advantage, Putin is unlikely to flinch first.

Given the stakes, the EU and Russia will most likely try to avoid having the crisis escalate further. That would be the economic equivalent of a nuclear bomb, or mutual assured destruction.