Economic impact of war in Ukraine could go from bad to worse

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What will be the economic consequences of the war Russian president Vladimir Putin is waging in Ukraine? That question may not be quite as important as the cost in lives lost and shattered, children orphaned and communities uprooted. But it is almost as important because the economic fallout affects lives (and livelihoods) too, and because economic developments may in time influence the outcome of the war itself, or the diplomacy that will one day replace it.

It is, of course, too soon to give a very informative answer. But we can at least collect some of the most useful early observations. What are the economic effects of the war on Ukraine itself, how are sanctions hitting the Russian economy and what will be the wider economic impact elsewhere?

On Ukraine, the war itself makes it extremely hard to measure the economic situation with any precision. With millions of Ukrainians fleeing their homes and many cities under bombardment, ordinary economic activity must, to a large extent, be suspended. Then there is the physical damage. A week ago, the Ukrainian president’s economic adviser put the damage at $ 100bn already.

An IMF staff report, completed on March 7, includes this telling fact: in normal times, half of the country’s exports rely on the port of Mariupol, which is now suffering the most savage siege. The IMF’s tentative projection is for output to fall 10 per cent in 2022 – if the war does not last long. The fund’s analysts do not mince words: “Downside risks are exceedingly high.”

What about Russia? The precise combination of sanctions placed against it has never before been imposed on a large, globally integrated economy – so we have little to go on to predict how big the impact will be, other than that it will be large. But as Branko Milanovic points out, Russia has faced huge downturns before: after the 1917 revolution (s) and again at the end of communism and in the 1998 currency and banking crisis. (One could add the famine Joseph Stalin inflicted on Ukraine in the 1930s.)

Where to place today’s economic hit in comparison? Milanovic suggests “it is not going to be as sharp as in 1992, nor as (relatively) mild as in 1998” so we can, “very roughly, put the expected decline in 2022—23 at high single digits, or low double digits ”. That chimes with projections cited in my Financial Times colleagues’ latest article on how Russians are experiencing the sanctions (see chart below), and is a tad less optimistic than the Institute of International Finance, which forecasts a 15 per cent drop in Russia’s output this year, with the risk “clearly tilted to the downside”.

Annual change in gross domestic product showing Russia's economy is expected to contract sharply this year

What this looks like on the ground is a return to the Soviet Union: no more travel, missing or low-quality goods. Sergei Guriev, the former chief economist of the European Bank for Reconstruction and Development, says in an interview that medicine prices could rise 50 to 100 per cent. How bad things get, he says, depends on whether current sanctions will be followed by an oil and / or gas embargo, and how much China helps Russia get around sanctions, in particular by providing technological goods. It is easy to imagine unexpected supply chain problems emerging because parts or services can no longer be procured from other countries.

In Milanovic’s words: “The problem is that, in the current situation, there are almost no good policy choices to make. . . It will no longer be the question whether one likes price controls or not: it would be a question of having massive riots without them. ” He adds that the inevitable smuggling will have social consequences: “The criminalization of the Russian society, which has gone on since the 1990s and that exploded under [Boris] Yeltsin, will come back in force. The coming years of Putin’s rule will thus look very much like the worst years of Yeltsin’s rule. ”

The prospects are very dark, then, for both Ukraine and Russia, and the numbers that analysts are bravely putting on paper may, if anything, be too optimistic.

My gut feeling is that the same is true for the economic repercussions in Europe and the wider world. We are facing huge negative supply shocks with several dimensions: high energy prices above all, but also high food commodity prices and the shock of disrupted trading patterns, refugee flows in Europe and radical geopolitical uncertainty. So far, western central banks seem determined to tighten monetary policy in the face of this supply shock (whether they are wise to do so is a topic to return to in a future Free Lunch). Even fiscal policymakers are not, yet, in emergency mode.

The European Central Bank, which accelerated its wind-down of bond purchases last week, did so on the back of economic projections of higher inflation, caused by the rise in commodity prices, but a still decent growth rate. Even in its worst alternative “severe” scenario, eurozone growth in 2022 clocks in at 2.3 per cent. In a simulation published today, the OECD suggests a hit of 1 percentage point to global growth from the war (and a 1.5 percentage point hit in the eurozone).

Adam Tooze used a recent issue of his excellent newsletter to report the German debate around the economics of ending imports of Russian energy, as I and many others have called for. In the most optimistic analyzes, the German economy can adapt to lower imports at negligible cost. (That sort of adaptability is presumably also what underlies the benign ECB take on the supply shocks we are facing.) At the most pessimistic end of the spectrum are analyzes suggesting a cost of several percentage points of output. Tough, but not unbearable.

These forecasts may well prove correct (and to be clear, we should stop paying Moscow for oil and gas even if they are too optimistic). But I have a niggling worry that standard economic modeling tools could fall short in predicting the effect of this sort of crisis. Remember two economic lessons from the pandemic: interdependent and complex supply chains mean that small disruptions in one place can be seriously amplified somewhere else; and a significant supply shock can lead to an even greater demand shock.

Policymakers are beginning to trace out the possible repercussions of the Ukraine war around the world. The most obvious link is food prices, which are already soaring, and will no doubt rise further if the Ukrainian sowing season is not salvaged soon. Just one example in an IMF round-up of global repercussions should make us feel very nervous: Egypt imports 80 per cent of its wheat from Russia and Ukraine. With many countries in Africa and the Middle East being similarly exposed, Europe could soon have another migration crisis on its hands, on top of millions of Ukrainian refugees.

Another weak link that took at least me by surprise is Ukraine’s role in supplying many of the rare gases needed in industrial processes – such as neon, krypton and xenon – including already beleaguered semiconductor production.

The point is this: the standard modeling tends to work best when intricate interdependencies do not take us by surprise. But at the moment, it seems reasonable to fear that any surprises we get will be bad ones. On the other hand, the pandemic also showed that policy can do a lot to counter bad surprises if our policymakers are willing to act. So we must hope the desire to “normalize” is not too strong with them.

Other readables

  • Like me, do you find it easy to get a bit lost in the sanctions flurry? Chad Bown, of the Peterson Institute for International Economics, has published a timeline of all the sanctions imposed on Russia since February, to be updated in real time.

  • The outcome of Putin’s war on Ukraine is deeply uncertain. But, as I argue in my latest column, that is no reason not to plan for how to build peace if Russian forces can be pushed back.

  • Lukasz Rachel punctures no fewer than 16 myths in order to debunk those arguing we should keep buying Putin’s oil and gas.

  • Notwithstanding the war in Ukraine, Federal Reserve chair Jay Powell is unleashing his inner hawk.

    Changing FOMC projections for the midpoint of US interest rates from March 2021 to September, December, and March 2022

Numbers news

  • It’s not news, really, but it feels new to see it so starkly illustrated. The people alive today make up a fair chunk of the number of people ever lived, but the future of humanity is probably much, much larger. Do read the full reflections on “long-termism” by Our World In Data’s Max Roser.

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