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.

Redrawing the economic map

As Europe awoke to the news that Russia has launched military action against Ukraine, it is hard to avoid the conclusion that the geopolitical tectonic plates have shifted. A war on this scale in continental Europe is not something we have seen since 1945 although we should not forget that the Soviet Union did invade Hungary in 1956 and Czechoslovakia in 1968, so there is a parallel (albeit inexact). Twenty years ago it all seemed very different. Having experienced a form of shock therapy following the collapse of the Soviet Union in 1991, which saw hyperinflation and a huge collapse in output, the Russian economy stabilised in the late-1990s. Accession to the G8 in 1997 gave rise to hopes that it would become a reliable international partner whose political and economic interests would be more aligned with the west. The annexation of Crimea in 2014 changed all that.

From a geopolitical perspective, Russia has become an increasingly difficult problem for the west to manage. To quote the British parliamentary Intelligence and Security Committee, “Russia is simultaneously both very strong and very weak.” It is a significant military player with a permanent seat on the UN Security Council. Yet it has a relatively small population compared to the west and a weak economy which is heavily reliant on hydrocarbon revenues. This makes it difficult to respond effectively. Military engagement by the west in Ukraine is out of the question, although matters could escalate if former Soviet Republics which are now NATO members (Estonia, Latvia and Lithuania) face a similar threat. That is something we would rather not think about. But as a response to the Ukrainian incursion, it is clear that the west will implement economic sanctions.

Germany has already paused its certification of the Nord Stream 2 gas pipeline. Whilst this does not mean that the pipeline will never be used, it is a significant move and will have major implications. Although Chancellor Scholz wants to wean Germany off imported Russian gas, the view in Moscow is this will be impossible in the short term and may not even be possible on a 5-10 year horizon. This is indeed plausible and the 2011 decision to end nuclear energy generation now looks rather ill-judged. However, now that the Greens are part of the government coalition, their resolve to further reduce dependency on fossil fuels should not be underestimated. Either way, this is likely to have significant costs for one or both parties – we cannot predict at this point where the incidence will fall.

How effective will sanctions be?

The German case was merely the most high profile of a range of sanctions introduced in recent days (the British government’s efforts were a particularly weak response) and more will be forthcoming. Sanctions are now regarded as the first response to aggressor nations and in contrast to the old maxim of “shoot first and ask questions later”, the Peterson Institute for International Economics (PIIE) acknowledges that “advance planning for the imposition of sanctions is now the norm.” But what are they designed to achieve? There are a range of possibilities. Sometimes they are simply implemented to satisfy domestic considerations rather than influence the actions of others; they may be designed to send a signal that the actions of others are unacceptable, or they may be intended to implement regime change. Whether or not sanctions are successful depends on which of these is the intention. 

A study by PIIE suggested that sanctions tend to be effective in roughly one-third of cases. But the success rate depends very much on the objectives. “Episodes involving modest and limited goals, such as the release of a political prisoner, succeeded half the time. Cases involving attempts to change regimes (e.g., by destabilizing a particular leader or by encouraging an autocrat to democratize), to impair a foreign adversary’s military potential, or to otherwise change its policies in a major way succeeded in about 30 percent of those cases. Efforts to disrupt relatively minor military adventures succeeded in only a fifth of cases.” The invasion of Ukraine is not a “minor military adventure” so the odds that sanctions will reverse the outcome are limited. In any case, as PIIE notes, “sanctions are of limited utility in achieving foreign policy goals that depend on compelling the target country to take actions it stoutly resists.” US efforts to promote political change in Iran and Cuba are testimony to this. Furthermore, according to PIIE: “It is hard to bully a bully with economic measures” since the evidence suggests that democratic regimes are more susceptible to such pressure than autocracies.

In order to manage expectations, western governments have to make it clear at the outset that they do not expect economic sanctions to facilitate regime change in Russia or reverse the Ukrainian invasion (although Putin did suggest in his speech that Russia does not intend to occupy Ukraine). What kind of sanctions could the west impose? The first option would be to sanction the free flow of Russian capital by imposing restrictions on those with close links to the government, the rationale being that pressure placed on Putin by power brokers would destabilise his grip on power. This would include restrictions on their personal activity and also the banks that they use.

There have also been calls to cut Russian access to SWIFT, the global interbank payments system. Whilst this would severely impact on Russian banks, European creditors would also struggle to get their money out of Russia. This would be particularly problematic since BIS data indicate that European banks hold the vast majority of foreign banks' exposure to Russia (chart above). Russia also has huge FX reserves, totalling around $630 billion, which would mean that it has no immediate need for market access to foreign currency. It also has its own financial payments system (SPFS) which funds around 20% of Russian settlements. However, the Atlantic Council think tank reckons that “the Russian equivalent of SWIFT remains mostly aspirational [and] is much ado about nothing,” concluding that its importance is overblown.

One concern is that sanctions on Russia could drive it further into China’s orbit as the two countries have become closer in recent years as they seek to weaken US hegemony. But China has to balance its relationship with Russia against its need to preserve relationships with the west and it has nothing to gain from any conflict with Ukraine. However, closer Chinese ties may weaken the impact of any economic sanctions that the west might impose (for example, if China were to become a bigger importer of Russian oil and gas).

Implications for the west

Thirty years ago much of the talk in policy circles was of the peace dividend that would accrue as a result of reduced defence spending. That dividend now appears to have been used up and recent events may force governments to think about raising defence spending. Only seven of the 30 NATO members currently spend more than 2% of GDP on defence – the benchmark which all members are meant to achieve by 2024. Increased defence spending will stretch public finances more than in the period 1945-90 because ageing populations mean that health services are a bigger competitor for tax revenue. It is therefore possible that taxation will have to rise in order to pay for it.

More generally the era of peace, prosperity and openness characterised by increased globalisation is apparently in retreat (see the KOF index). Russia may not be the superpower of old but it is big enough to cause problems if it flexes its muscles. China waits in the wings, perhaps assessing the west’s response to the Ukrainian invasion as it ponders how to deal with Taiwan. For those of us old enough to remember the Cold War, none of this is new. Nor does it necessarily mean huge changes in the way we live our day-to-day lives. But governments will have to make increasingly difficult choices about resource allocation as we revert to a world of “them and us.”