Is Europe moving towards a “war economy”?

Published 8 Apr. 2022, 13:37

It is possible that the war in Ukraine will become a prolonged conflict between the Western world and Russia, and then it is necessary to foresee that the European economy will become what can be called a “war economy”. What are the characteristics of the “war economy” and, therefore, what can be expected in the future in Europe?

Feature number one: high inflation

The first characteristic of the “war economy”, already visible in Europe, is the sharp rise in the price of raw materials; with supply difficulties, with high demand for energy and metals (because military and infrastructure spending is increasing).

Hence the high inflation, the severe loss of household purchasing power, the hardship for companies that consume raw materials, and the need for the state to support the incomes of low-income households, most affected by rising energy prices.

Second: the destruction of economic interdependencies

The second characteristic of the “war economy” is the destruction of economic interdependencies between conflicting countries. This is a strong shock, because companies, value chains, supplies of raw materials were built between countries in the logic of striving for interdependence, for free relations between countries.

Thus, today we see anxiety caused by the presence of numerous European companies in Russia, Europe’s dependence on raw materials produced in Russia (oil, natural gas, metals, wheat, etc.). Natural gas accounts for 10% of the energy consumed in Europe.

Third: a sharp increase in government spending

The third characteristic of the “war economy” is a sharp increase in government spending (military spending, infrastructure, supporting the income of the population in conditions of high inflation). Today, these additional public spending are added to the spending adopted after the Covid-19 crisis (health, innovation, reindustrialization, etc.) and to the spending associated with the energy transition.

Therefore, we must expect a rapid increase in government spending and a permanent opening of government deficits. This will create two problems. What to do with budgetary rules in Europe: should they be suspended while the war is going on? And how to finance the persistently high government deficit? This raises questions about monetary policy.

In a war economy, the central bank can no longer fight inflation. Moreover, the inflation that results from commodity prices and government spending has nothing to do with monetary policy and cannot be contained by monetary policy. The role of the central bank in the “war economy” is simply to help finance government deficits.

Therefore, it must monetize the public deficit, buy large amounts of public debt, maintain very low long-term interest rates, and therefore effectively give up fighting inflation. Then there are extremely low real interest rates (nominal interest rates far below inflation), allowing government debt ratios to stabilize despite very high government deficits.

If Europe were to truly transition to a “war economy”, the dynamics of the economy would be very different from what was expected after the Covid-19 crisis. We expected a fairly rapid decline in inflation and the state deficit, a gradual normalization of monetary policy, but none of this happened.

This would reveal a very large asymmetry between the Eurozone and the United States, where the Federal Reserve will fight inflation, where the government deficit will sharply decrease from 2022, and the economy will be very little affected by the war in Ukraine, in particular with energy quasi-autonomy from the United States.

Patrick Artus is an economic adviser to Natixis.

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