The long and the short: Part 2

Just after the first part of this note was published, the US and Iran negotiated a fragile ceasefire which appeared to involve the reopening of the Hormuz Strait. Donald Trump and his acolytes attributed this to his threat that “a whole civilisation will die tonight” unless the waterway was reopened. Iran, for its part, insisted it had successfully resisted the military pressure brought to bear on it. Indeed, the Strait remains closed – an Iranian demonstration of how it still holds a lot of the cards.

In truth, there are no real winners. Iran has taken heavy punishment from US and Israeli attacks which have degraded a considerable part of its military capacity and resulted in thousands of civilian casualties. But the US may have lost something even more important – credibility. It cannot claim to have achieved its initial goals of regime change and elimination of the Iranian nuclear programme (despite claims that the programme was ‘obliterated’ in 2025). The Iranian government remains in place even after the assassination of Supreme Leader Khamenei; it retains the ability to launch missiles against its neighbours and it still possesses its stock of enriched uranium. Moreover, Iran has now exerted control over the Strait of Hormuz, a waterway where it once merely harassed shipping but where it now dictates the terms of passage for the 20% of global oil traffic that flows through it.

History suggests that previous episodes of Western involvement in the Middle East have exacerbated rather than improved local security conditions. Recent cases have included the 2001 invasion of Afghanistan and the 2003 invasion of Iraq which precipitated acute sectarian polarisation and a near-disintegration of Iraq’s social fabric. Nothing that has happened in recent weeks suggests that the cycle will be broken this time around. Indeed, events since 7 October 2023 have ratcheted up global tensions in a way not seen since the Yom Kippur war of 1973. Israel’s actions alone have represented a disproportionate use of military force but US strikes against Iran represent an even more consequential strategic miscalculation, with the potential for far‑reaching geopolitical repercussions.

1. US actions will have more adverse geopolitical consequences than previous episodes

The litany of miscalculation and bombast on the part of the US Administration needs no repetition here but it is having profound consequences which could lead to a change in the geopolitical order. Although it made less strident claims during the Vietnam War, the US made a similar geopolitical miscalculation in the 1960s when launching its military power against a supposedly weaker opponent. But it was able to recover from that episode by virtue of being the unchallenged global economic leader. While the war placed fiscal and social strains on the US, the underlying economic engine was so powerful that recovery was almost structurally guaranteed. Along with this economic dominance, the US retained its position as the leader of the western alliance. Today, the size of China’s economy means it is now a near‑peer economic rival, while India and the EU represent sizeable economies that dilute US dominance. Trump’s erratic foreign policy means that erstwhile allies no longer have the same degree of trust in the US, whose leadership of the western alliance has been severely strained.

2.   The western alliance has experienced a profound change

None of this is to say that the US will not remain the strongest western power, both economically and politically. A post‑Trump administration may well re‑anchor US foreign policy in its traditional liberal democratic values, leading to a renewed warmth in transatlantic relations. But as the journalist Lewis Goodall recently noted, the widening gulf between Europe and the US MAGA movement is increasingly about values and “the divide runs deeper than policy, deeper than politics, deeper than any single leader can bridge.”

Trump’s recent threats to pull out of NATO would certainly undermine European security guarantees. But it would also reduce US ability to project its power around the globe. At the same time, efforts to draw European partners into the Middle East war and Trump’s ambitions towards Greenland have reminded Europe that partnership is not the same as dependence, and that it cannot afford to outsource its interests. It now understands the limits of external guarantees and the need to take fuller responsibility for its own security and economic resilience.

This will, of course, have serious military and economic implications for both Europe and the US. In 2023 and 2024, more than half of non-US NATO military spending went to US-owned companies, so the US stands to lose economically if Europe reduces its dependency. But Europe is also heavily dependent on the technology embedded in US-produced military equipment which will not be easy to replace (for a fuller discussion of these issues, see this excellent piece from the Bruegel think tank). The western alliance has served all sides well over the last 80 years. Its demise would not benefit any of its members.

3.   Trump has played into China’s hands

Large parts of the Middle East, particularly the Gulf states, have traditionally adopted a pro-US stance, relying on it for protection from hostile actors. But Iran’s missile attacks on Gulf states which host US military facilities have raised questions about just how much protection the US is able and willing to give. This raises the incentive for them to be more amenable to Chinese overtures as China seeks to expand its sphere of influence.

In East Asia, questions have been raised around China’s ambitions towards Taiwan and how far the US would be prepared to go to defend it. It is notable that Cheng Li-wun, the chair of Taiwan’s Kuomintang (KMT), this week met with Xi Jinping in Beijing, the first such contact in a decade. While there is no suggestion that the People’s Republic is planning a military invasion, Chinese military planners will undoubtedly have taken on board just how quickly the US is prepared to expend resources in pursuit of its goals, and how Iran has been able to absorb the military onslaught against it. Indeed, one of Trump’s biggest blunders has been to expose the limits of military power when confronted by a determined adversary. Deterrence is strongest when overwhelming force is implied, not when it must be used, particularly when it does not actually achieve its goals.

4.   Acceleration of global fragmentation

Historians may look back at the events of March 2026 and conclude that this was the point at which the position of the US at the top of the global geopolitical order became less certain. China has been able to sit on the sidelines and watch the US alienate its allies. One outcome might be a reduction in reliance on the US for security and a greater willingness to explore trade and financial payments infrastructure based on anchors other than the dollar. It is important to emphasise that this will not happen overnight – there will be no sudden rupture – but it could result in a gradual erosion of US dominance as parallel networks gain traction at the margin. This risks a more fragmented global landscape characterised by competing spheres of influence, reduced policy coordination and a diminished capacity to collectively manage cross-border shocks.

5.   Rising tail risks

One cause for concern is that there will be a significant widening in the distribution of risks. A global environment which has been built on a system of deterrence and sharply delineated red lines is increasingly subject to ambiguity. This increases scope for miscalculation by multiple actors operating in close proximity which in turn raises the likelihood of low-probability, high-impact events, ranging from unintended military escalation to a more sustained disruption of critical chokepoints (as we are seeing in the Strait of Hormuz today, but this could equally be a disruption of computer chip supply or some other critical material). In this environment, these risks are not independent: an initial shock could trigger a cascade of responses, amplifying its impact well beyond the original incident. The result is a more unstable equilibrium in which periods of apparent calm mask an underlying increase in systemic vulnerability, and where geopolitical developments are more likely to generate abrupt and non-linear shifts in the global landscape.

Last word

Some, all or none of the above risks could materialise. It may be that the Trump era represents a temporary blip in the global order and that the west will settle on a stable equilibrium once he leaves office. But it would be complacent to assume a return to the old normality. Something has fundamentally changed: the certainties of the old global order have given way to a more volatile and fragmented system, where stability can no longer be assumed and where shocks, whether geopolitical or economic, are likely to be both more frequent and more disruptive. And this is likely to have economic costs as European countries make greater provision for defence spending, diverting resources away from more productive investment and placing additional strain on already stretched public finances. A more fragmented and less predictable global environment will weigh on trade, investment and policy coordination, reinforcing the drag on growth. The cumulative effect is a world economy that is not only more exposed to shocks, but less well equipped to absorb them.

Vladgrind

My initial thought twelve months ago following the Russian invasion of Ukraine was that the tectonic plates have shifted. Nothing that has happened in the interim has caused me to change my view. It soon became obvious that the war was going to be a more protracted affair than Vladimir Putin anticipated (or was told by his advisers) and slightly belatedly the west realised that it had a duty to provide physical support to show that its support for democracy amounted to more than just words. There has been a cost, both economically and geopolitically, and the issue over the next twelve months will be whether the international community is prepared to continue paying the price.

Polling evidence shows that Europeans and American citizens believe Ukraine should continue its fight to regain the territory occupied by Russia, although in other geopolitically important states there is less support for such a position (chart above). The continental European position is understandable. There is more concern than elsewhere that the war could spill over and draw them in to defend their territory or that of their neighbours. Quite how events will pan out over the next twelve months is difficult to say. The likelihood is that the war of attrition will continue, with Ukraine not having the resources to push Russian forces out of their territory but Russia unable to make significant territorial gains. Further ahead, the manpower differential makes it difficult to see how Ukraine can regain the territory it has lost without regime change in Moscow, suggesting that some form of negotiated settlement might be the best we can hope for.

The economy has so far avoided the worst case outcomes …

Undoubtedly the Ukrainian war has had a big impact on the global economy, following hard on the heels of the Covid pandemic. This has manifested in an inflation shock, the likes of which we have not seen in 40 years, and prompted central banks around the world to raise interest rates, having kept them at historical lows for far too long after the GFC. The slowdown in the global economy has been pronounced but perhaps less dramatic than anticipated towards the end of 2022, with euro area GDP eking out a small rise of 0.1% q/q in 2022Q4, thus ensuring that the economy continues to avoid recession. Germany is facing a tougher haul but even the 0.4% contraction recorded in Q4 was better than anticipated a few months ago.

Germany in particular has coped far better than anticipated in managing its gas storage. As of end-February, storage levels were at 71.7% of capacity (chart below) whilst gas consumption in the week beginning 13 February 2023 was 22.7% below the average for 2018 to 2021. As a consequence, Europe’s largest economy has avoided significant blackouts which has prevented sharper falls in output. But contrary to suggestions expressed in the media of late, we are far from out of the woods. Indeed, although it is likely that Germany – and indeed the rest of Europe – has sufficient gas on hand to get through to the autumn, much depends on how easily gas storage levels can be topped up ahead of the winter. In the event that Germany cannot easily top up supplies from non-Russian sources in 2023, we could go into next winter with perilously low supply levels which would be problematic if there is a cold winter.

… But …

A tightening of monetary policy has helped to curb demand but this all points to the fact that rather than a winter 2023 recession, we could instead face a similar outcome in twelve months’ time. For this reason, markets are looking nervously at the actions of central banks as they continue to tighten monetary policy in the face of a rising inflation threat. But it is not headline inflation they care about so much as the pickup in core inflation as prices respond to the big rise in energy costs that occurred in 2022. On top of this central banks also care about the prospect of a response from wage inflation which could set off a wage-price spiral. So they keep nudging rates higher. And the higher they go, the more likely the prospect that the economy finally tips into recession – not as a direct result of higher energy costs but as a result of tighter monetary policy.

That might seem a remote prospect in the US today but the operation of monetary policy involves lags which are often not known with any precision. As interest rates in the US rise and inflation falls, so the real interest rate – which is assumed to be a key factor in driving real activity rates – becomes less negative. Based on latest data, for example, the real Fed funds rate climbed from a low of -8.2% in March 2022 to -1.8% by January 2023. Admittedly this is still in negative territory but add 25bps to the funds rate and assume inflation comes down by another 1.5 percentage points to 4.8% and the real rate is back at zero. The further inflation falls as the energy price shock drops out of the calculations, the greater the upward pressure on real rates and the bigger the drag on the US economy – and by definition the rest of the world.

Back to where we started

Putin calculated that NATO’s European members, which were heavily dependent on Russian gas, would scale back their opposition to the invasion as the restriction of gas supplies put intolerable pressure on the European economy. So far this calculation has not worked out. European opposition may yet soften if the economy falls into recession, either as a result of domestic policy errors or those of the Federal Reserve. However, rather than a short, sharp recession, it is far more likely that the European economy will experience a longer period of little to no growth, which will raise the pressure on policymakers in different ways. Coupled with high budget deficits, which may prompt some form of fiscal consolidation, the near-term outlook for the European economy is not a pretty one. The polling data suggests that European governments can afford to stay the course in 2023. Whether they will be prepared to do so further ahead as elections loom may be another matter.

Pieces in the puzzle

Just as the fall of the Berlin Wall in 1989 kick started the wave of globalisation, so the Russian invasion of Ukraine threatens to throw the process into reverse. Whereas its rise was initially a slow process which only seeped into the wider consciousness around the turn of the century, the reversal of globalisation is likely to take the form of a screeching U-turn as the west reassesses its security and economic needs. Whether or not the fighting in Ukraine quickly comes to an end, it is clear that Russia under its current government will remain an untrustworthy geopolitical partner which will require governments to reassess their political alliances. This in turn will have consequences for the shape of the global economy.

Assessing China’s position

The role of China will be particularly fascinating. Prior to 2008 it was hoped that China would align more closely with the west as rising prosperity convinced the government that opening up the economy would be in its best interests. That has proved a forlorn hope. An ever stronger China has continued to plough its own political and economic furrow with ambitions of usurping the US to become the dominant Asian power. It is ultimately likely to achieve that goal one way or another. At issue is the timing and the extent to which this transition occurs peacefully or otherwise.

It was therefore particularly interesting to hear suggestions that Russia has asked China for financial and logistical support for its invasion of Ukraine which further complicate the geopolitical mix. Whether China will agree to do this remains unclear. Last month, Russia and China extended the 2001 Sino-Russian Treaty of Friendship for another five years which commits China to support Russia “in its policies on the issue of defending the national unity and territorial integrity of the Russian Federation.” It also states that “when a situation arises in which one of the contracting parties deems that peace is being threatened and undermined or its security interests are involved or when it is confronted with the threat of aggression, the contracting parties shall immediately hold contacts and consultations in order to eliminate such threats.” Clearly, the ties between the two are very strong although it is questionable whether China expected Russia to launch its invasion which runs counter to its interests.

A particularly interesting article by Hu Wei, vice-chairman of the Public Policy Research Centre of the Counsellor’s Office of the State Council, suggests that China’s alignment with Russia could cause more problems than it solves. The thrust of the text is that if the conflict were to spiral, with NATO becoming involved, Russia cannot win by military means which would raise US influence on the global stage and leave China more isolated. He suggests that “China cannot be tied to Putin and needs to be cut off as soon as possible … Being in the same boat with Putin will impact China should he lose power. Unless Putin can secure victory with China’s backing, a prospect which looks bleak at the moment, China does not have the clout to back Russia.” It is important to stress that this does not reflect government policy and the fact that it was submitted to the Chinese-language edition of the US-China Perception Monitor and translated into English suggests it was designed for a western audience.

The official Chinese position views the world in zero-sum terms: What is good for the US must be bad for China (although the Trump administration was guilty of the same mindset). It does not have to be this way and rather than issuing threats about how the US would react – wielding the big stick would likely prove counterproductive, especially since China is aware of the consequences – a better approach may be to highlight the benefits of the cooperation which China claims to value. Whilst we should not expect China to publicly oppose Russia’s actions, at the UN or elsewhere, it has more potential than any other external force to act as a restraining influence.  

China is also aware that it runs significant reputational risk if it aligns itself with Russia and has more to lose than to gain if the west does decide to loosen economic ties. Moreover, Russia’s actions will cause problems for one of China’s signature economic policies – the Belt and Road Initiative. The BRI is designed to create a land route across central Asia, linking China to consumer markets in western Europe and raw material producers across Europe and Asia. War in eastern Europe will disrupt the supply of commodities to China and elsewhere, particularly in the event of a protracted conflict. It is thus in China’s economic interests that the war in Ukraine is swiftly resolved.

Big questions for Europe

From a European perspective, the western alliance has come together far more quickly and in a more unified fashion than we have seen for many years. The EU’s actions are a reminder that it has its roots in a project designed to ensure that the continent would not revisit the ravages of the first half of the twentieth century – a point that was lost on large parts of the UK electorate during the Brexit referendum. With the spectre of conflict once again at the EU’s border, the nature of the union is likely to change. The commitment to raising defence spending will mean more expansionary fiscal policies across Europe. During the Cold War, European economies routinely spent around 3% of GDP on defence. Recent figures suggest that this has slipped to around 1.5%. In order to boost outlays will mean either higher taxes or an increase in debt issuance (and this is before we discuss the costs of dealing with the refugee crisis).

In addition the rush to diversify away from Russian energy sources will impact on living standards for many years to come as the relative cost of energy remains elevated. This may also have implications for the EU’s green agenda. Whilst there are increased incentives to diversify away from hydrocarbon fuels, it will be difficult to make the sudden switch to renewables. Consequently, many EU countries may be forced to extend the lifetime of coal-fired power stations, rather than using gas as a transition fuel until such times as renewable sources come online.

Across the continent, governments are likely to be far more engaged in economic management than has been the case for many years, which they will justify on national security grounds. As this post from the Breugel think tank pointed out, the private sector may have responsibility for the generation and distribution of energy but has no responsibility for ensuring security of supply nor for ensuring that consumers have access to energy. The private sector may also be unwilling to carry the costs of replenishing supplies at current prices, for fear of huge losses in the event that oil and gas prices fall. All of this suggests that significant fiscal intervention may be required to guarantee energy supply.

Europe has perhaps been too complacent about the risks emerging from the geopolitical sphere in recent years, partly because it has had to cope with the aftershocks of the Greek debt crisis and Brexit. However, it has acted remarkably swiftly in the last three weeks as latest events highlight that the time for complacency is over. In the wake of the 2008 crash, hopes were expressed that we could return to the old world order. The pandemic and the war in Ukraine suggest that we are likely to return to a geopolitical order more reminiscent of 1985 than 2005.