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Ukraine’s War: The Economic Impacts

Three questions to Eric Chaney

Ukraine’s War: The Economic Impacts
 Eric Chaney
Senior Fellow - Economy

Russia’s invasion of Ukraine, which began on February 24, has resulted in a full-blown war. The Western world’s condemnation of Vladimir Putin’s actions has been reflected, among other things, in the implementation of significant economic sanctions against the Russian regime. It is still too early to tell how the conflict’s repercussions will fully unfold, but the initial economic consequences are already being felt. What do these economic impacts consist of? And what can we expect, over the coming months, in countries affected-directly or indirectly-by the Russia-Ukraine conflict? Eric Chaney, Economic Advisor to Institut Montaigne, shares his analysis. 

How will the war in Ukraine, and sanctions against Russia, affect the global economy?

The world is facing a major stagflation shock, although one less violent than that which occurred between 1973-1974.

But before analyzing these global circumstances, we should talk about Russia. By sidelining itself from the Western world, Russia is embarking on the destruction of the modern, outward-looking part of its economy. Excluded from the international financial system and subject to a partial embargo of American and European imports ranging from technology to aircraft parts, it is entering a spiral of inflation and depression, with the ruble losing 32% of its value since the beginning of the year, and 72% since the annexation of Crimea. The regime still benefits from oil and gas sales to Europe, which continues despite the atrocities being committed in Ukraine. Within this context, I would like to draw attention to a call to stop financing Putin’s war launched by a group of economists-of which I am a member-through implementing the three measures of an oil embargo, a tax on gas imports, and tax transfers to low-income earners to help cushion the shock.

In the event of a prolonged occupation of Ukraine, however, the Russian economy would permanently contract.

The future is not entirely closed off for Russia. If a satisfactory agreement is quickly reached, the sanctions currently striking the heart of the Russian economy could be lifted. In this event, the shock would be transitory, and the economy would recover. In the event of a prolonged occupation of Ukraine, however, the Russian economy would permanently contract. Based on the sanctions already in place, the IMF estimates that Russia’s GDP will fall by 7% during 2022.

This number seems almost insignificant in light of the severity of the sanctions, but it follows high growth during early 2022. Instead of an annual average, if we measure the GDP between the end of 2021 and the end of 2022, the drop would likely be much steeper. But that’s not the most important thing. Putin’s strategy is leading Russia into a lasting depression, with a permanent loss of 15% to 20% of output, and a decline in real incomes of at least that much. Putin’s dream of a pivot towards Asia is an illusion: cut off from the West, Russia would merely become a vassal of Chinese power.

Let’s get back to the global economy. It is facing a large-scale supply shock on multiple fronts: supplies of fossil fuels, wheat, potash, nitrogen fertilizers and industrial metals such as nickel and titanium, which together make up the bulk of Russia’s (and Ukraine’s) exports, have been severely reduced. The result is an increase in world prices for all these commodities, as we have seen in a particularly volatile manner with nickel.

Before the invasion of Ukraine, there was already talk of the risk of stagflation due to the rising price of raw materials and bottlenecks in global production chains. But that fear was transitory, supposed to fade away once the supply chains returned to some degree of normalcy. Now, everything has changed-not only will the shock be much larger and affect a wider spectrum of channels, it is also likely to last longer.

Supply shortages will inevitably reduce activity in those sectors already affected by previous shortages or delivery delays, particularly the automotive and electronic component industries. At the same time, rising inflation will reduce the purchasing power of consumers. This giant shear will reduce economic activity while accelerating inflation: this is indeed stagflation-with the resulting job losses and cuts in corporate profits leading to reduced investment and, eventually, soaring budget deficits.

This giant shear will reduce economic activity while accelerating inflation: this is indeed stagflation.


As I previously said about Russia, the consequences of the stagflationary shock strongly depend on the war’s duration. In the best-case economic scenario of a rapid peace agreement, an envisaged return to conditions before the invasion would be slow to arrive. Central banks would need to deal with further rises in inflation, but their ultimate problem would remain working out how to bring inflation down without stalling the recovery. In the more likely case of a stalemate and further extended sanctions, the world economy would find it more challenging to return to a balanced growth path due to costly and time-consuming adjustments to supply chains.

This will affect all countries, albeit to different degrees. In Europe, for example, France and the United Kingdom engage in less trade with Russia than Germany and Italy do, and as such, it is the latter two that will be hit harder.

The Minister of Finance spoke of a shock of similar magnitude to that of 1973, do you agree?

Indeed, the oil shock of 1973-1974 was a huge negative supply shock for the world economy. The new flows of petro-dollars from oil importers to OPEC were not a zero-sum game due to the low propensity of the oil kings to consume their new and immense revenues. The consequent endemic inflation and low growth led to the coining of the term "stagflation." This occurred in conjunction with several other factors that had slowed productivity prior to the oil shock. The Minister’s is therefore justifiable. 

However, I see three critical differences between now and 1973.

  1. The initial size of the shock is smaller. Between 1973 and 1974, the price of crude oil jumped 370%. Assuming that the cost of oil stabilizes at around $110/bl (as of March 28, Brent crude was trading at $113/bl), the increase over 2021 and 2022 would be 180%, a huge jump, but only 60% of that in 73-74. 
  2. Developed economies are significantly less dependent on oil and less energy-intensive overall than in 1973. The case of France is particularly revealing-in 2019, fossil fuels consumption was 71% lower than in 1973. Other things being equal, the French economy is now three and a half times less sensitive to price variations in fossil fuels. Although the cost of electricity has also risen significantly, which was not the case back then, when prices were under government control, a conservative estimate projects a shock three times smaller than that of 1973-74.
  3. In 1973, the world economy was far less interdependent than today. While the oil shocks of the 1970s brought about a kind of globalization through the opening up of OPEC oil-producing nations to world trade, the Soviet Union, China and India all remained outside. Today, China dominates world trade, both in exports (12.2% of world exports) and imports (11.2%). Assuming that China is less affected than OECD countries, the world economy would benefit from a shock absorbing structure that did not exist in 1973. Conversely, a Covid-linked shutdown of Chinese factories would make things worse.

As we can see, comparisons with 1973 have their limits. As far as the French economy is concerned, INSEE provides a balanced perspective in its most recent Note de Conjoncture. We really should mention the remarkable work of the experts at INSEE, who have expertly extracted as much information as possible from numerous business surveys in order to assess the situation properly. Correctly emphasizing the significant uncertainties created by the war and the duration of sanctions, they provide two particularly pertinent insights.

After February 25, French business leaders immediately revised their outlooks downwards, particularly in retail and industry. It is worth noting that a comparable survey by the New York Fed had already revealed similar reactions. However, at this stage, services and construction were much less affected. Rising prices and their impact on consumption explain the pessimism of the retail industry, while for manufacturers, it is more likely the risk of shortages in essential materials that is of concern.

Based on the Banque de France’s baseline scenario of 3.4% in 2022 and 2.0% in 2023, growth would slow to 2.4% in 2022 and 1.5% in 2023.

In addition, INSEE simulated the short-term impact of the current increases in energy prices using macro-economic models and without assuming any economic policy response. The result was a 0.7% reduction in French GDP for 2022, compared to what the situation would be without the shock. For the Eurozone as a whole, the OECD predicts double at 1.4%; the difference is explained by more restrictive assumptions and the fact that France is less exposed than the Eurozone average.

Let us assume that the impact on France over 2022 is around 1% of GDP and, in the case of a prolonged war, growth is reduced by a further half point in 2023. Based on the Banque de France’s baseline scenario of 3.4% in 2022 and 2.0% in 2023, growth would slow to 2.4% in 2022 and 1.5% in 2023. This is obviously a significant shock, but not on the scale of the 6 points of percentage loss following October 1973. Moreover, the economic slowdown would not be sufficient to significantly increase unemployment, although employment growth may slow.

What should be expected from economic policies to reduce the shock?

Prior to the invasion of Ukraine, economic policy choices were constrained by guidelines which could be summarized as "do enough, but not too much."

Fiscally, the aim was to reduce the public deficits created by the pandemic, but not so fast and hard as to break the recovery. France embarked on this path, but with its usual caution. The "inflation cheque", the decision to cap increases in gas and electricity prices-a strange way of reacting to an energy supply shock, since it does all it can to ensure that demand does not fall-had already seriously affected the budget deficit reduction path. The budget will be further strained by the decision to provide a 15 cents a liter rebate on diesel and gasoline bills for four months. Although this decision can also be criticized on the same basis as the energy caps, it does have the advantage of being a temporary instead of a difficult-to-reverse tax cut. The previously envisaged budget deficit reduction, from 8.4% of GDP in 2021 to 4.8% in 2022, will therefore be significantly reduced, with a deficit of 6% of GDP looking more likely.

In fact, we could be witnessing a paradigm shift. The approach of "whatever it takes" during the Covid crisis, which made survival possible through minimizing the economic damage, could continue by adopting the stance of a war economy, and applying the "whatever it takes" policy-but for new reasons.

In fact, we could be witnessing a paradigm shift.

We find ourselves in unprecedented times: the erupting horrors of war on the borders of the European Union; the transformation of an authoritarian regime - that expresses its Euro-hostility through back-door methods such as supporting Europhobic political parties - into a dictatorial regime with the largest number of nuclear warheads on the planet; the threatening of the worst reprisals against those who dare stand up to Putin. All these factors will have profound effects on worldwide economic policies. Germany’s (temporary) decision to triple its military budget is the clearest example of this.

With regard to fiscal policies within the Eurozone, this will most likely mean increased relaxation by the European Commission on budget deficits monitoring. The impact of the stagflationary shock, increased military spending, the costs of receiving refugees (which it would be wise to consider as an investment) and accelerating investments in energy infrastructures to escape dependence on Russia- these are all elements that result in increased public spending. It would not be a surprise if the Next Generation plan, jointly financed by an extension to the EU budget, were soon followed by the emergence of a similar program that is now dictated by the war economy.

But how can we finance these increased budgetary needs? Raising taxes amid a stagflationary shock would be counterproductive. This leaves the option of increasing debt. Some additional room for maneuver has appeared here, thanks to the fall in real interest rates that has itself been caused by fears of rising inflation. The U.S. Federal Reserve, which has just raised its key rate by 0.25% and made clear this was only a first step, has barely managed to reverse the decline in real interest rates: as of 25 March, the real five-year interest rate implied by inflation-indexed Treasury bonds was standing at -1.2%. This is what the "war economy" paradigm means. In this context, the ECB will likely be even more cautious. It is even possible that it will go as far as launching a new purchase program for government debt, if the shock were to last for an extended period-in which case, it would set aside the target of 2% inflation for better days ahead.





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