LLess than three months after Russian troops crossed the Ukrainian border, the economic implications of the war are gradually being felt. There have been other conflicts since 1945, but it is hard to imagine one that had such a dramatic and sudden impact. The only real comparison is with the 1973 Yom Kippur War.
Support for Ukraine is widespread in the West, among governments and the public, but it is only now that the consequences of sanctions and embargoes are beginning to be felt. This week, the US Federal Reserve and the Bank of England raised interest rates in the face of annual inflation rates heading towards 10%. The European Central Bank will follow in the coming months.
The threat of recession is obvious. Central banks say they are powerless to stop rising global energy prices from driving up the cost of living, but believe they can prevent high inflation from taking hold. Former Chancellor of the Exchequer Norman Lamont once said that higher unemployment was a “price to pay” for controlling inflation, and that sentiment still persists.
Last year, central banks assumed that inflationary pressures would be temporary. There would be bottlenecks as demand increased as countries emerged from lockdown and supply struggled to keep up, but any problems would soon disappear. Analogies have been made with the audience leaving a theater at the end of a play: there is a rush at the exit but it doesn’t take long before everyone is out in the street.
In fact, things were a bit more complex than that, with more pent-up demand resulting from the lack of spending opportunities during the coronavirus pandemic than central banks thought and more degraded supply chains. The imbalance between demand and supply has since been exacerbated by two factors – the war in Ukraine and China’s zero-tolerance approach to Covid 19 – but it was already driving up inflation in the second half of 2021.
These global shocks affect countries in different ways. As Bank Governor Andrew Bailey pointed out this week, the United States is facing what looks like a demand shock, with a tight labor market, strong consumer spending and less exposure. to energy prices due to their status as major gas producers. The Eurozone experiences a supply shock because it has a weaker labor market than the United States and is more exposed to rising energy prices. Britain has elements of both: it is experiencing a supply shock from the rising cost of energy and food but, like the United States, it has low unemployment.
Everywhere, however, the story is one of higher inflation, slower growth and tough choices for policymakers. Olaf Scholz, the German chancellor, has been criticized for wanting to limit the damage caused to his country’s economy by the war. In truth, it simply asks an obvious question: how much pain can governments impose on their populations before support begins to wane?
This question only becomes more relevant as collateral damage increases. For now, the impact of war is being cushioned by the opening up of economies as the Omicron variant of Covid 19 becomes less of a threat. Unemployment will continue to fall in the US, UK and Eurozone for a few months. Things get complicated later.
The end of the Cold War in the early 1990s allowed Western governments to cut defense spending and reallocate money elsewhere. Fewer tanks and warships meant more could be spent on health and education without taxes having to be raised. If, as seems likely, the Cold War returns, tougher choices will have to be made, and at a time when aging populations intensify pressures for increased spending.
There are other long term implications of the war. The EU must develop a new energy strategy on the hoof as it weans itself off Russian oil and gas. Long global supply chains look less attractive than they did pre-Covid, and self-sufficiency is back in fashion. Both of these factors threaten to push prices higher, at least in the short term.
It is clear that it is not easy to adopt an appropriate policy in these circumstances and that delicate decisions are taken by central banks and ministries of finance. Central banks will suffer a loss of credibility if they allow an inflationary spiral to take hold, but the monetary overpower that pushes their economies deeper into recession won’t do much for their reputation either.
However, the real responsibility lies with finance ministers, because fiscal policy – tax and spending decisions – is more effective in the current circumstances than monetary policy.
In the UK, Rishi Sunak seems in no rush to add to the limited support he gave in the spring statement, preferring to wait for the autumn budget to act. Pressure for a summer mini-budget is likely to increase, however, as by August a new energy price cap will be announced to take effect in October. That looks like adding an extra £800 a year to the average household’s bill, bringing it to around £2,800. Millions more will fall into fuel poverty.
It is not a question of whether there is more help, but how generous this support is and when it will be deployed. It is unrealistic for governments to imagine that support for Ukraine will continue at its current high levels as queues begin to grow and living standards begin to really erode.
There is a trade-off here: if foreign policy is to remain hawkish toward Russia, then domestic policy must become more dove in helping those most affected by the economic consequences of war.