War between Russia and Ukraine means that Europe will no longer return to normal

War between Russia and Ukraine means that Europe will no longer return to normal

German Chancellor Olaf Scholz, French President Emmanuel Macron and Polish President Andrzej Duda attend a press conference ahead of a Weimar Triangle meeting to discuss the ongoing crisis in Ukraine, in Berlin, Germany, February 8, 2022.

Hannibal Hanschke | Reuters

The war in Ukraine and the resulting economic sanctions against Russia will cause far greater shifts for Europe’s economy and markets than previous crises such as the coronavirus pandemic, economists said.

In light of Russia’s unprovoked invasion of Ukraine, European leaders are forced to make swift plans to reduce their excessive dependence on Russian energy. The European Parliament on Thursday called for an immediate and total embargo on Russian oil, coal, nuclear fuel and gas.

However, this aggressive decoupling has come at a cost to the European economy, pushing already high inflation to record levels and undermining the manufacturing recovery that started last year as economies tried to bounce back from the Covid-19 pandemic.

ING Head of Global Macro Research Carsten Brzeski noted last week that Europe, in particular, is at risk of losing its international competitiveness as a result of the war.

“For the continent, the war is much more of a game-changer than the pandemic once was. I’m not just talking about security and defense policies, but especially about the entire economy,” Brzeski said.

“The eurozone is now experiencing the downside of its fundamental economic model, that of an export-oriented economy with a large industrial backbone and greater reliance on energy imports.”

After benefiting from globalization and the division of labor in recent decades, the eurozone must now ramp up its green transition and pursue energy autonomy, while simultaneously ramping up spending on defense, digitization and education. Brzeski described this as a challenge that ‘can and must succeed’.

“If and when that is the case, Europe should be well positioned. But pressures on household finances and incomes will remain enormous until that happens. Corporate profits will remain high in the meantime,” he said.

“Europe is facing a humanitarian crisis and a major economic transition. The war is taking place in Europe’s ‘granary’, a major production area for grain and maize. Food prices will soar to unprecedented levels. Higher inflation in developed economies could be an issue of life and death in emerging economies.”

Brzeski concluded that financial markets were “misguided” as European equities tried to move higher, adding that “there is no return to any sort of normalcy at this point.”

Debt sustainability concerns

This tectonic shift for the European, and even global, economy will put additional pressure on central banks and governments caught between a rock and a hard place in juggling inflation and fiscal sustainability, economists acknowledge.

In a note Thursday, BNP Paribas predicted that a faster drive for decarbonisation, higher government spending and debt, stronger headwinds to globalization and higher inflationary pressures would be an ongoing theme.

“This backdrop presents central banks with a more challenging environment to implement policies and keep inflation on target, not only increasing their ability to commit to a particular policy path, but also increasing the likelihood of policy errors,” said BNP Paribas Senior European Economist Spyros Andreopoulos. †

He also noted that raising interest rates to curb inflation will ultimately make life difficult for tax authorities.

“While this isn’t an immediate concern, not least because governments have generally extended the average maturity of their debt in the low-interest-rate years, a higher interest rate environment could also change the budget calculation. the sustainability of debt could resurface,” Andreopoulos said.

Low inflation in the eurozone’s recent history has never forced the European Central Bank to choose between fiscal sustainability and pursuing its inflation targets, as low inflation necessitated the accommodative monetary policy that promotes fiscal sustainability.

“Politically, the ECB was able – convincingly in our view – to fend off accusations of helping governments by pointing to low inflation results,” Andreopoulos said.

“This time, the ECB must tighten its policy to contain inflation against a background of even higher government debt, a legacy of the pandemic and ongoing pressure on the treasury.”

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