What is the economic impact of the European War in Ukraine?

Russia’s invasion of Ukraine is an unprecedented act of violent warfare, the duration of which is still unpredictable. Our intention is to limit ourselves strictly to the area of ​​our capabilities and to address only the macroeconomic outlook of this war against the European economy.

First of all, this war will significantly change the old budget arbitration in terms of military spending in many European countries. Indeed, the relative weakness of the armed forces of European countries was emphasized as well as the geopolitical cost of this weakness. General re-arming is on the agenda, as re-industrialization was prioritized in 2020. In particular, Germany has already announced a budget target for military spending of about 2% of GDP, compared to 1.2% annually for the 10 years from 2010 to 2020 (SIPRI data). This transition to an anti-war economy has strengthened the weight of the state in the economy by directing resources directly to defense industry bases.

Demand shock and supply shock

Strictly at the macroeconomic level, the economic consequences of war are similar to the economic consequences of a deadly pandemic. Like the war with Covid-19, the war in Ukraine causes both demand and supply shocks.

Demand shocks are primarily the result of consumer and investor reaction to the sharp rise in uncertainty. Household consumption declines in favor of savings. Investment is also declining, with companies moving to a cautious and wait-and-see attitude, with the exception of the defense sector. The evolution of European stock exchanges since the beginning of the conflict clearly reflects this climate. Net demand from overseas may also deteriorate. On the export side, it is worsening with the same logic as the decline in domestic demand. On the import side, rising prices for energy, minerals and certain agricultural products will significantly increase billing.

Supply shocks are primarily due to rising energy costs, with oil already rising 20% ​​compared to 80% of weekly gas prices. Brent went from $ 91 to $ 111 and the spot price for gas in Germany went from € 95 / MWh to € 175 / MWh. The same applies to certain numbers of metals such as palladium, vanadium and titanium, where Russia is a major producer, especially those essential to the automotive and aviation industries. Ukraine is a major wheat exporter, with 36% of the world’s wheat trade (and 80% of sunflower oil) passing through the Black Sea. The supply chain creates new disruptions and high production costs.

Rising shipping costs

In fact, many sub-suppliers of the Eastern European industry have been established in Ukraine and are no longer able to supply their European customers. A subsidiary of a European company founded in Russia (and a branch of a Russian company founded in Europe) is closed and Russia finds itself trapped. Finally, shipping costs should also increase. In particular, overflight from Russia is banned, so not only air cargo with Asia but also sea cargo should increase.

These two shocks (supply and demand) intensify each other’s negative impact on economic activity. On the other hand, the net effect on price depends on the relative size of each other. Indeed, demand shocks have a repressive effect on prices, and supply shocks have an impact on inflation. In our intuition, the supply shock will be even greater.

European leaders find that supply shocks are always facing a complex economic situation, with difficult trade-offs between inflation and unemployment. The problem is that the options are now narrowing due to the consequences of past trade-offs in favor of unemployment during the Covid-19 crisis. This new supply shock is already in the euro area, with inflation rising at 5.8% and high public debt (100% of GDP in the euro area). Meanwhile, European countries have returned to relatively low levels of production and unemployment before the Covid-19 crisis.

ECB needs to tackle inflation

External and internal conditions do not allow us to expect a reduction in public spending in the short term, but rather an increase, which should lead to an increase in national debt. be. Nor can the European Central Bank (ECB) price stability targets be changed. This must attack inflation without further delay to prevent permanent deterioration of inflation expectations. It is dangerous for the ECB to try to support its activities and debt a little more by keeping the key rate at zero and implementing an asset purchase program. Escaping inflation poses a structural risk and puts a heavy burden on the purchasing power of the middle class and working class. This is a phenomenon that is currently poisoning the President of the United States. Nevertheless, this arbitration could change if the situation of the conflict with Russia expands and turns into an arms race. In that case, the political priority will be support for economic activity and defense, “whatever the cost”.

As long as it is unfortunately a permanent situation rather than a temporary one, it seems unwise to limit the rise in gas, oil and energy prices by administrative restrictions. Such implementation of energy subsidies would be very costly to finance due to its non-transient aspects. Similarly, this limit stimulates gas and oil consumption, but it is better to strategically stabilize or even reduce it.

Emmanuel Macron took the lead and began to prepare public opinion by arousing the considerable costs that the war in Ukraine would bring to our society.

Consider raising taxes

If this conflict with Russia is destined to continue, the European government cannot do it without considering tax increases. Who says war, war effort and war contribution. In addition, such measures to divert resources from personal consumption to consumption and public investment will have a significant deflationary effect.

It is desirable for us to raise taxes and fairly distribute the burden of war to all French, rather than weigh the burden of the poorest due to possible shortages associated with inflation and controlled prices. am.