Taking into account the recession caused by war

I am an optimistic person by nature, especially when it comes to the economy and financial markets. When many are pessimistic, I always come up with some reasoning why that pessimism is not justified. Remarkably often, my optimism turns out to be justified. Most problems are solved in one way or another and most things end up on their feet. However, my optimism is now completely failing me.

I read that French President Macron spoke with Putin on Thursday. The latter is said to have said to continue fighting until he has all of Ukraine under control. It is no longer possible to comprehend what is going on. Ukraine is being physically extremely damaged and Russia is being completely isolated economically. The optimist in me says that people in Putin's 'inner circle' will depose him, after which the struggle will be stopped and everything normalizes. But it gnaws great, because why haven't they already done that for a long time?

The economic sanctions against Russia seem very successful in causing economic and financial pain. The ruble has fallen sharply, after which the Russian central bank has raised interest rates sharply. The amount that Russians can take out of the country in dollars is limited. The stock exchange is closed, but Russian companies with listings elsewhere are severely punished. Russia's credit rating has been reduced to 'junk'. A large number of Russian banks will no longer be able to use SWIFT, which will largely stop international trade and the central bank has lost access to a large part of the foreign exchange reserves. Meanwhile, more and more Western companies no longer want to do business with or in Russia. This is an unprecedented expression of unity. It is almost inevitable that Putin will eventually finance his war monetarily, so that after some time Russia will fall prey to hyperinflation.

In the days of the Soviet Union, the following economist joke was sometimes told. During the military parade on May 1, a small group of men neatly dressed in tailor-made suits walk through Red Square among all the weaponry. A foreign diplomat asks the Soviet president what those men are doing there. "Those are economic advisors, you should know how much damage they can do," was the answer. In my opinion, politicians who have gone astray are capable of inflicting immeasurably more economic damage than economists.

All this does not affect us economically. Just when the pandemic seems to be coming to an end, life is normalizing and we could look forward to a reduction in logistics disruptions, falling inflation and steady economic growth, that beautiful prospect is being shattered. Perhaps my pessimism is now going too far, but I think that in Europe we should seriously consider a period of economic contraction: recession. In any case, the war in Ukraine is hitting the European economy much harder than the American one, causing what economists call an asymmetric shock.

I assume that because of the sanctions and the like, exports to Russia will come to a complete or almost complete standstill. Because of the war, I also assume that exports to Ukraine will come to a halt. Before the war, the export of goods to Russia and Ukraine accounted for about 5% of the total exports of all euro countries. That was about 1% of GDP. For America, trade with Russia and Ukraine is of course much less extensive: 0,5% of total exports and 0,04% of GDP. Note, however, that there are major differences between euro countries when looking at the European figures. So there is also an asymmetric shock within the eurozone. Lithuania is the hardest hit. Trade with Russia and Ukraine accounts for almost 40% of the total export value, and about 10% of GDP. There will (have to be) EU emergency funds.

A second mechanism through which the war is affecting the eurozone economy is through oil and especially gas prices. At the time of writing, the European gas price is approximately €175 per mWh. Now the European gas price had already risen sharply before the war. We have to realize that the gas market is much less international than the oil market because a lot of gas is transported by pipeline, which of course has a limited and fixed reach. Before the pandemic, the European gas price was around €20 per mWh or even slightly less (see graph). So that current price is about nine times that!

The price of gas has also risen in the US, but much less. In the next image, I've shown the US gas price on a similar scale to the previous image to emphasize the difference. The gas price in the US is currently more than double what it was before the pandemic. Annoying for the Americans, but not ninefold!

In addition, the United States is approximately 90% self-sufficient in oil and more than self-sufficient in gas. Europe is only self-sufficient in oil for a quarter (and then largely by Norway and the UK) and for 35% in gas (again Norway and the UK). For our economy, the increased oil and gas prices are therefore causing a significant national impoverishment, in contrast to the US, which is not getting much worse as an economy as a whole.

A third possible link through which the war could affect our economy is if Russia decides to reduce or stop supplies of oil and especially gas. I don't know how dependent Putin thinks he is on the revenues from these supplies, but in the past Russia has always retaliated against sanctions imposed by Western countries. Now that he's engaged in a brutal war, I think he could just turn off the gas tap. The ECB has sometimes argued that a sudden 10% cut in gas supplies would reduce GDP in the eurozone by 0,7%. Now we have to take these kinds of figures with a grain of salt, but it is obvious that a total stop of supplies would imply economic chaos. Perhaps an enticing prospect for Putin…

The graph of US exports to Russia clearly shows that they reached their peak before the annexation of Crimea in 2014. The decline that subsequently started, partly due to Russian retaliatory sanctions, has never been caught up. A similar picture can be seen in Dutch exports of food and live animals.

Eurozone inflation further up
Inflation in the eurozone rose further in February: 5,8% against 5,1% in January. That was a setback. Core inflation was 2,7%.

Inflation in the eurozone is broadening. Of course, energy remains the main culprit. Energy prices were 31,7% higher than a year ago and this spending category has a 10,9% weight in the inflation basket. Of the 5,8% inflation, approximately 3,5 percentage points is therefore due to energy. Of course, that still leaves 2,3 percentage points for the remaining nearly 90% of the inflation basket. The average inflation rate of the rest of the inflation basket is therefore about 2,6%. The following chart shows that prices for non-energy industrial goods (about 27% of the inflation basket) have risen as fast as they are now in the euro era. Prices for services (about 42% of the inflation basket) are also rising relatively quickly.

In the current circumstances, the ECB can really do little else than sit back and watch. A recession in the eurozone cannot be ruled out and you do not want to tighten monetary policy on the eve of a contraction.

War in Ukraine will hit European economy hard
The war in Ukraine will hit the European economy hard. And certainly much heavier than the US economy. The high inflation had already eroded purchasing power before the war, but then we expected a further decline in inflation during the course of this year. The outlook for inflation has deteriorated markedly as a result of the war.

The blows to the European economy are:

• Trade with Russia and possibly Ukraine will come to a complete standstill. Before the war, exports amounted to about 1% of GDP. In the US it was about 0,04%.
• As a result of the war, European gas prices have risen sharply, those in the US much less. That erodes our purchasing power much more than that in the US.
• Europe is highly dependent on oil and gas imports, which means that the increased prices mean a national impoverishment. The US is more or less self-sufficient.
• Europe must take into account that the Russians can reduce or stop oil and gas supplies. That would shut down some of the economic activity. The US does not run that risk.

In a black but plausible scenario, the economy in Europe will fall into recession within a short time. Policy makers will support the economy. However, it should be borne in mind that the ECB does not have much effective policy space and the pandemic has already weighed heavily on public finances in many European countries.

The US central bank looks set to raise interest rates later this month. That will be the first step in a series. That in itself is understandable, because inflation is much too high there too and the potential damage of the war is much less than with us. Still, you wonder whether interest rate hikes are wise in the current situation. Financial markets are nervous enough as it is. I hold my breath. Well, I already started this review with that.

Hans de Jong

Han de Jong is a former chief economist at ABN Amro and now a resident economist at BNR Nieuwsradio, among others. His comments can also be found on Crystalcleareconomics.nl

© DCA Market Intelligence. This market information is subject to copyright. It is not permitted to reproduce, distribute, disseminate or make the content available to third parties for compensation, in any form, without the express written permission of DCA Market Intelligence.