Some days ago, a friend of mine sent me a “fake news” joke saying: “Putin Receives Nobel Prize in Medicine for Ending COVID Pandemic”. Under different circumstance, it would have been a funny joke. But there is nothing funny about what is happening in Ukraine right now which has indeed displaced the world’s attention away from the pandemic. Much is being said about the conflict and its consequences. While militarily the war is circumscribed to Ukraine, its economic impact is global.
The International Monetary Fund (IMF) says Russia's invasion of Ukraine will harm the global economy in many ways. Its managing director, Kristalina Georgieva, singles out the food crisis: “The impact of this war on the food prices is going to be quite dramatic. The wheat in the ground is being destroyed. We are going to have shortages and face higher costs. War in Ukraine means hunger in Africa. Take for example Egypt: 80% of their food imports come from Ukraine and Russia. Imagine this country with food prices jumping and riots on the street...”
Europe is particularly affected. Its dependence on Russian energy is being described as an uncomfortable truth. Another uncomfortable truth is how the war in Ukraine will negatively impact the European economy. According to the president of the European Central Bank Christine Lagarde: “The war will have a material impact on economic activity and inflation through higher energy and commodity prices, the disruption of international commerce, and weak confidence. The extent of these effects will depend on how the conflict evolves, on the impact of current sanctions and on possible further measures.” The ECB has revised his inflation forecast for the current year from 3.2% to 5.1% which is the highest level since the creation of the single European currency.
Many economists fear that the fallout from the Russian invasion of Ukraine will lead to “stagflation”, i.e., it will reduce global growth and raise global inflation over the next year. The IGM Forum at Chicago, which regularly polls some of the world’s top economic experts in Europe and the US for their views on topical issues of public policy, invited its panel of economists to express their views on the potential consequences for the European economy, for global growth and inflation.
On the question “Will the fallout from the invasion reduce global growth and raise global inflation over the next year?”, over three-quarters of the panel agree, and the rest are uncertain. Karl Whelan at University College Dublin, who strongly agrees, says: “This is a classic negative supply shock. As we know from the 1970s, these shocks raise inflation and reduce output.” Robert Shimer at Chicago is less certain: “It’s an adverse supply shock. Whether that is inflationary depends on the monetary policy response.”
On the question “Will a total ban on oil and gas imports risks recession in European economies?”, 70% agree and most of the rest are uncertain. Christopher Pissarides of London School of Economics indicates: “Germany is totally dependent on Russian gas. A recession in Germany will bring recession to Europe.” Several panellists express the view that, even if an energy embargo were to be costly for Europe’s economies, it may still be desirable. Some indicate that, despite the costs to Europe, an embargo may be still be warranted as they believe that it will not necessarily lead to a severe recession in Europe.
In Germany a lot of people are angry because they know that gas imports are financing the Russian war activities. Some leading German politicians are demanding an immediate stop to gas imports from Russia. But half of the Germany households use gas for heating and around half of the gas comes from Russia. Thus, the government is resisting saying it would be a threat to Germany's energy security.
Overall, the main risks to the European economy arise from: 1) the shock triggered by the increase in oil and gas prices, 2) from its dependence on Russian energy, and 3) from the impact of geopolitical threats on household confidence and investors’ sentiment.
When facing a commodity price shock, the standard prescription is that the central bank should essentially tackle the second-round effects. It should not embark on a futile attempt to control the immediate impact of price rises on inflation (on which increases in the interest rates have very limited effect, if any), and it should accommodate permanent relative price changes. In the very short term, the ECB is likely to wait and see. But it may soon be forced to make a politically difficult choice between tolerating inflation remaining above target for longer or raising interests rates and weakening the economy in the midst of a geopolitical confrontation.
In most EU countries, governments have introduced measures to contain the rise in prices and to support vulnerable households. But the question is whether governments should rely primarily on transfers (which can be targeted but do not contribute to prevent inflation) or should intervene through tax cuts and price controls (which will affect the consumer price index, but are much more costly budget-wise).
The war context is pushing governments toward implementing more direct price interventions than they would normally consider. In Portugal, the CCP (Confederação do Comércio e Serviços de Portugal) is appealing the Government and demands “strong and urgent measures against the price hike”. CCP considers that, if urgent measures are not taken to mitigate the effects of rising prices in key areas such as fuel, electricity and commodities, many companies, already weakened by two years of the pandemic, will have to close, or suspend their activity. CCP asks the Government to adopt a series of robust measures, namely: treasury support (loans guaranteed by the State and the possibility of converting part of this loan into a non-repayable subsidy); reduction of the VAT rate on fuel to the intermediate rate; and review the VAT tables for a set of essential goods, namely food products.
The invasion of Ukraine is an important historical turning point. The war will inevitably lead the EU and national states to depart from standard policies, and into a messy world in which governments interfere with markets for security reasons, where politics trump economics and monetary and fiscal policy become strongly interdependent. Whatever the duration of the war, its legacy will be long-lasting. It will shape Europe’s policy choices for the years and decades to come. So far, the expectation in the EU was that decarbonisation, digitalisation and resilience investments would dominate the medium-term agenda. Security – both economic and defence security – is now added to this agenda.
This article was originally published in Jornal de Negócios in 16.03.2022