Clifford G. Gaddy and Barry W. Ickes of the Brookings Institution -

“[T]he central paradox of financial crises is that what feels just and fair is the opposite of what’s required for a just and fair outcome.” 
— Former US Treasury Secretary Timothy Geithner, 
The New York Times, November 5, 2011

Sober analysis of the current standoff over Ukraine tells us we are in a deep mess, worse than people tend to recognize. The events playing out now are bigger than Ukraine. Both Russia and the West are deeply committed to broader objectives that seem fundamentally irreconcilable. There are no easy solutions to the crisis.

Timothy Geithner's remarks are even more appropriate because Russia, through its current actions in Ukraine, has exposed the post-Cold War order in Europe as the geopolitical equivalent of a financial bubble. We have enjoyed two decades of benefits from this order. But we did so under the illusion that it was nearly costless. Now we are finding out that there is a bill to pay.

The missing quadrant

We can explain by using a simple framework that we first developed in 2008 after the Georgia crisis. Imagine a matrix with two columns – one labelled “Strong Russia” and the other “Weak Russia” – and two rows, one for “Good Russia” and the other for “Bad Russia.” Into the quadrants of this matrix we place the various “future Russias,” as most western policymakers envisioned then in the early 1990s.

The first possible Russia was one that would reform and succeed – that it would accept the so-called Washington consensus and develop its democracy, resulting in a strong Russia that is "good" (ie. positively inclined toward the West). The second Russia would try to reform but fail and remain weak, but was still “good.” In the third option, Russia would reject reforms altogether and remain weak, and it would refuse to accept the US-led post-Cold War international order and so be “bad.”

But note that there is one quadrant that is missing. What could not be imagined at the time was a “strong, bad” Russia. Hence, no probability was attached to that outcome. All this would have been rather academic except that the assumptions of this matrix were taken as the basis for the entire post-Cold War order.

With the collapse of the USSR and the end of the Warsaw Pact, the US took the lead in establishing a new international political order in Europe. The Iron Curtain separating West and East would be torn down, and the former Soviet republics and satellite nations of Eastern Europe would be transformed into Western-style market democracies. But clearly this would be a wrenching process and so needed a big carrot to persuade the countries to participate: membership in the premier Western clubs, the EU and Nato.

The promise of Nato membership was the key. No matter how much lip service the Eastern Europeans paid to the virtues of free markets, democracy, civil society and so on, they took on the burdens of reform for one main reason: to earn a guarantee of protection against their age-old enemy, Russia.

But what was not recognized was the US assumed this perceived “Russia threat” was not real and never would be. It was assumed that Russia would slide further backwards and would always be weak, never to threaten the US-lead world order. A "strong, bad" Russia was unimaginable. This was precisely the “missing quadrant."

The insurance scheme

When a particular bad outcome is unimaginable, there is little cost to selling insurance against this possibility. It's like selling a put option that is far out of the money, as it assumes no one will exercise this option. The newly independent countries were keen to buy insurance, as they didn’t see a missing quadrant: for the countries of Central Europe the Russian threat remained real. And the US was keen to sell the insurance, because it didn’t see any danger of having to pay out on that insurance.

However, there is a moral hazard that comes with selling insurance, as the insured parties take bigger risks than they otherwise might. That is exactly what happened in the case of new Nato members, Poland and the Czech Republic, for instance, which quickly began to lobby to have American missile defence systems on their soil – something seen by the Kremlin as more threatening than Nato expansion itself. If you are Russian President Vladimir Putin, you want to indicate to the US the cost of these deployments – that the risk (and hence the cost) is not zero – which led directly to the Georgia conflict of August 2008.

The message was not received, however, much like the collapse of the subprime market should have foretold what was to come in the financial crisis. What we should have recognized between August 1998 and August 2008 was that the unimaginable had occurred: Russia had become "strong, but bad.”

The bill comes due

What brought this about was the rise of oil prices from under $50 per barrel to over $100. As Figure 2 shows, by the early 1990s the world oil price had been collapsing for more than a decade and a world with $100-plus oil was also unimaginable, similar to if Martians had taken over the Kremlin. It was outside the realm of possibility.

Nato expansion was the geopolitical equivalent of a financial bubble, where housing prices are expected to always rise and the costs are ignored until the bubble bursts. The bill for Nato enlargement is now far overdue. The bigger the bill gets, the nastier the bill collector, in this case Vladimir Putin, has to be. And he is not going to go away until we pay the bill.

But many seem unwilling to acknowledge the bill and are trying to avoid paying. We did this before. The US response to the war in Georgia in 2008 was the so-called "reset" – a wishful attempt to return to the halcyon days of the Clinton-Yeltsin era by betting on then-president Dmitry Medvedev to maintain the illusion of the missing quadrant: that Russia could be "good."

The response in the Ukraine crisis today is different, but equally inadequate. We have imposed a set of modest economic sanctions against Russia. They are not so strong as to cause real pain, but we pretend they are enough to stop Putin and let us return to business as usual.

In fact the sanctions will not deter Putin from his strategic goal of eliminating what he perceives to be direct security threats to Russia. Indeed, the various “purely-for-show” military measures being discussed by the West – increasing American troop presence and weapons deployment in Eastern Europe and sending Nato trainers to Ukraine, Georgia and Moldova, for instance – will likely reaffirm for Putin that his message has gone unheard once again and thus guarantee that he sooner or later makes another, even more shocking, move.

The bailout

The West is facing three options to deal with the Ukrainian crisis and the wider problem of what to do about Russia.

Option 1: Total bailout = total fulfilment of Nato commitments. Place military bases and missiles throughout Central Europe and turn Ukraine into a new West Germany.

Option 2: Complete default = complete abandonment of all Nato commitments. Walk away from the Nato commitments and let Russia have its head in Europe.

Option 3: The Geithner doctrine. Acknowledge Russia's rising power and working with the Kremlin to bring peace and stability in Ukraine.

Only the third option is realistic. Just as we could not let the entire financial system collapse, we cannot walk out on current members of Nato. But at the same time insisting on beefing up Nato first and then expect to get Russia’s support in stabilizing Ukraine – support that is indispensable – is backward.

At every step of the way towards crafting a long-term outcome that is acceptable to both Russia and the West, we will have to heed the Geithner doctrine. We will have to make concessions that many people will regard as unprincipled and distasteful. The sooner we accept this reality, the better. The longer we wait, the more costly the solution becomes. We must recognize reality and forego the illusion of the missing quadrant.

Read the original (unedited) paper at www.brookings.edu/research/articles/2014/06/10-ukraine-nato-geithner-doctrine-gaddy-ickes

Clifford G. Gaddy is a Senior Fellow at the Brookings Institution and Barry W. Ickes is Professor of Economics at Penn State University and a Non-resident Senior Fellow at Brookings (http://www.brookings.edu)