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.

The long and the short: Part 1

As the US-Israeli war against Iran drags into its sixth week, the repercussions will be far-reaching. In the near-term, these are likely to be primarily economic. In the longer-term, the geopolitical ramifications will be more profound as the global order experiences what appears likely to be a permanent rupture. In the first part of a two-part note, I take a look at the economic aspects – drawing on an interactive VAR simulation dashboard to map the transmission of shocks – while the second part (forthcoming) will deal with the geopolitical consequences.

The magnitude of the problem

IEA Executive Director Fatih Birol, recently warned that “we are heading towards a major, major disruption, and the biggest in history.” It is almost certain that market conditions will get worse before they get better. Oil supply in March was partially supported by cargoes that had already passed through the Strait of Hormuz before hostilities escalated, and oil prices are already up 50% compared to pre-hostilities levels. If current estimates are correct that disruptions amount to 12 million barrels per day, this would amount to a 12% cut in global crude supply on an annual basis, compared to reductions of less than 5% in the 1970s. To put that into context, oil prices tripled – both in real and nominal terms – in 1974.

In an ironic twist, the 1970s oil shock was prompted by unconditional US support for Israel during the Yom Kippur war, which angered other Arab States so much that they imposed an oil export embargo. This led to increased tension between the US and several of its European allies who privately criticised the US for its reckless policy actions. US Secretary of State Henry Kissinger later admitted: “I made a mistake. In retrospect it was not the best considered decision we made.” It is unlikely that Donald Trump would ever make such an admission.

That was then. In many ways the world is very different. For one thing, although global oil consumption has doubled since the 1970s, European consumption in terms of barrels per day has remained broadly flat whereas Asian demand has increased fourfold, resulting in a big decline in consumption share for the former and a big rise for the latter (chart above). This is partly a reflection of European deindustrialisation whereby Europe now imports a lot of the manufactured products from Asia that previously would have been produced domestically. This has a double-edged effect: Asia will likely be much harder hit by the recent surge in oil prices than it was in the 1970s, while Europe will still end up importing inflation. Nor is the story these days purely about oil. Natural gas is increasingly used as a form of power generation, with global consumption having increased by 3.5x since the 1970s while European demand is up by 2.5x. So far, natural gas prices have not spiked to the same degree as they did in 2022: The Daily System Average Price (SAP) of Gas in the UK, which is an important determinant of retail prices, is admittedly up by 80% since end-February, but at 4.73p/kWh it is well below levels in excess of 19p/kWh in summer 2022. That said, matters might look different in a few months if energy does not start flowing through the Straits of Hormuz soon.

As it is, the pump price of petrol has risen sharply. US prices are now around $4/gallon, still 20% below the highs of summer 2022, but not a prospect that will endear President Trump to voters ahead of the mid-terms due in November (charts below). Similar trends are evident in the UK with a price around £1.54 per litre still 20% below 2022 highs (though at £5.83 per US gallon, or $7.59 at current exchange rates, UK motorists pay a lot more to fill up their cars). The price of petrol will feed through quickly into inflation. A rough rule of thumb is that every 5p on the fuel price adds 0.1pp to UK inflation, so on the basis of mid-March prices that will add 0.2pp to last month’s inflation rate. Latest data point to another 0.3pp in April. In the absence of energy effects, we could have expected UK April inflation to fall to the BoE’s 2% target rate as a number of base effects drop out of the calculations. On my calculations, that now looks unlikely.

Back in 2022, the huge surge in global prices triggered big increases in domestic energy bills. In the UK, domestic gas prices rose by 130% in 2022 though they are currently 35% below those peaks. In the short-term, consumers will be sheltered by the quarterly fixing of the household energy cap in April which means that any rise in domestic prices will only start to feed through from July. The econometric evidence suggests that it takes around 6 months for the full impact of global prices to feed through to UK consumers, which means we can expect significant increases in household energy bills in the latter part of 2026. On my calculations, the increase is likely to be at least 50% by end-year – and probably higher.

How do policymakers respond?

Even if we assume that the war ends tomorrow, the supply disruptions will take months to unwind, and it could take until end-year before supply is back to normal. But this optimistic scenario is one of the least likely options given the rhetoric out of Washington and Tehran in recent days. To frame the scale of the challenge facing policymakers, I have built an interactive VAR simulation dashboard (here) that allows users to explore how oil shocks and related variables propagate through the US, UK and euro area economies. It is not intended as a forecasting tool, but it provides a clear, model‑based sense of the pressures policymakers – particularly central banks – will have to weigh as they confront the next phase of this crisis[1].

The most obvious question is whether central banks should respond to inflationary shocks by tightening policy. In 2022, central banks responded to higher oil prices by raising interest rates. In one sense they could afford to do this because at the time of the Russian invasion of Ukraine, interest rates were at their effective lower bound. There was, in short, scope to tighten policy. Interest rates today are much closer to neutral. The extent to which rates should rise thus depends upon the extent to which second round effects are likely to impact the economy. In the US, the degree of labour market slack as measured by the unemployment rate is only modestly higher now than in early 2022. But in the UK the unemployment rate currently stands at 5.3% and rising, versus 3.9% and falling in early-2022. The number of  unfilled vacancies in the UK has fallen, suggesting softening demand for labour. All told, the risk of second round effects might be smaller than four years ago. The simulation model suggests that a sustained 50% rise in oil prices will add around one percentage point to UK inflation, and raise the risk of a modest 25bps increase in interest rates (50bps if we use the regime switching option). The ECB would be expected to respond with a 50bps rate hike whereas the Fed may even respond by cutting rates (charts below).

The other question is whether governments will be able to afford to use fiscal means to cushion households against rising energy bills in the way they did in 2022. In the UK, the net cost of support measures was roughly 2% of GDP in fiscal 2022-23. Hopefully the spike in the household energy price cap will be nowhere near as big as four years ago. Even so, a government which has set out its stall to balance the fiscal current account by the end of the decade will have precious little scope to provide any form of support. Indeed, as a senior British lawmaker put it to me recently, there is a question of whether governments should be providing such levels of support at all.

Last word

We can debate the pros and cons of Trump’s war (let us call it for what it is) but the economic consequences are unavoidable. A supply shock of this scale cannot be insulated by monetary policy or fiscal transfers. It will impact on prices and is likely then to affect wages and public finances, testing the political and economic cohesion of the global economy. The uncomfortable reality is that the costs will fall disproportionately on households and regions that had no role in shaping the decisions that triggered the crisis. The extent to which electorates are willing to absorb those costs is one that policymakers can no longer ignore.

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[1] The model includes GDP, CPI, the central bank policy rate and the trade weighted exchange rate (UK and euro zone)/unemployment rate (US). Users can simulate the impact of oil price changes; change the number of periods over which the disruption lasts; the pace of return back to baseline; the forecast horizon and whether they wish to operate in a low or high price regime. Separately, users can simulate the effects of changing endogenous variables with oil prices fixed. Please note that this is a work in progress. See the webpage for more detail.

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.