11 March 2022

Bruegel: The economic policy consequences of the war

The Ukraine war will have significant economic policy consequences for the European Union and its members, arising from the adverse supply shock triggered by the rise in oil and gas prices, energy independence measures, the inflow of refugees and boosted defence spending.

https://www.bruegel.org/author/jean-pisani-ferry/

The European Union has responded to the war at its Eastern border with exceptional unity, resolve and speed. But the invasion of Ukraine is a watershed. 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.

This blog post aims at providing a first assessment of the economic policy consequences of the invasion and the decisions taken since 24 February, when Russian troops entered Ukraine. The main immediate risks to the European economy arise from the supply shock triggered by the increase in oil and gas prices, from Europe’s dependence on Russian energy and from the impact of geopolitical threats on household confidence and investors’ sentiment. Europe also has the duty to welcome millions of war refugees and provide them with emergency assistance. In 2022 already, the direct budgetary impact of the corresponding decisions could amount to 1.1/4% of GDP, if not more. Longer-term, the EU is confronted with the need to boost defence spending in response to aggravated security threats and to rethink its energy system.

The upshot is that policymakers in Europe must pivot away from the expected post-COVID-19 normalisation and to join forces to tackle new emergencies. Longer term, they face a wholesale rethink of the EU policy system, which will affect budgetary priorities, principles for macroeconomic policies and market regulation and the division of tasks between the EU and its member states.

For the purposes of this blog post, many other channels, from the confidence shock to ripple effects on agricultural supplies and commodities markets, are left aside. I do not address either the broader, and critical, question of the potential fragmentation of the global economy that could result from the realisation that the ‘weaponisation of interdependence’ is no longer a matter for mere speculation.

Orders of magnitude provided in this blog post are extremely rough. They may prove wrong by a significant margin. The aim here is only to contribute to a discussion that must develop and will certainly result in much more accurate assessments.

1. Responding to a new supply shock

On the eve of the attack on Ukraine, the EU was already coping with a sharp deterioration of its terms of trade and with rising inflation, most of which was attributable to the price of imported energy. Although recovery from the pandemic shock is still incomplete and inflationary expectations are still somewhat below target, the European Central Bank was facing a difficult balancing act between looking through temporary price hikes and addressing the inflationary threats. The confrontation with Russia implies a more pronounced and longer-lasting shock, which will seriously aggravate the prevailing policy dilemma.

The standard rulebook when facing a commodity price shock is that the central bank should essentially tackle the second-round effects and avoid a potential escalation of inflationary expectations. It should not embark on a futile attempt to control the immediate impact of price rises on aggregate inflation (on which increases in the policy rate have very limited bearing, if any), and it should accommodate permanent relative price changes.

In the very short term, the ECB is likely to wait and see until it takes a decision. But it may soon be forced to make a politically difficult choice between tolerating headline inflation remaining above target for longer, and weakening the economy in the midst of a geopolitical confrontation. Its action will be further complicated by the risk that the spreads on government bond markets might widen...

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