The Russian War and the Global Economy

It is tempting to think that the war in Ukraine will have only a minor economic and financial impact globally, given that Russia represents only 3% of the world economy. But politicians and financial analysts must avoid such illusions.

NEW YORK – Now that Russian President Vladimir Putin has launched a full-scale invasion of Ukraine, we must consider the economic and financial consequences of this gigantic historical denouement. The war in Ukraine is not another minor conflict without global consequences like those that have happened in recent decades. It is a major escalation of the Second Cold War, in which four revisionist powers – China, Russia, Iran and North Korea – increasingly challenge the longstanding global dominance of the United States and the Western-led international order that was created after the Second World War.

The risk now is that markets and political analysts underestimate the implications of this global regime change. At the close of trading on February 24 – the day of the invasion – US stock markets had risen on hopes that the war would slow rate hikes by the US Federal Reserve. However, in terms of the broader economy, a global stagflationary recession is now immensely possible.

Analysts are wondering if the Fed and other major central banks will be able to pull off a soft landing after this crisis and its aftermath. Don’t count on it. The war in Ukraine will trigger a massive negative supply shock to the global economy, dampening growth and driving inflation higher at a time when inflation expectations are already becoming unanchored.

The impact of the war on the financial market in the short term is already foreseeable. Faced with a huge stagnant risk effect, global equities may move from the current correction range (-10%) into bear market territory (-20% or more). Government bond yields are sure to fall for a while and then rise after inflation unravels. Oil and natural gas prices will rise further – well above $100 a barrel – as will the prices of many other commodities, as both Russia and Ukraine are major commodity and food exporters. Haven currencies such as the Swiss franc will strengthen and the price of gold will rise further.

The economic and financial consequences of the war, and the resulting stagflationary impact, will obviously be much greater in Russia and Ukraine, and also in the European Union, due to their high dependence on Russian gas. But the United States will also suffer. Because world energy markets are so deeply integrated, a rise in global oil prices – as represented by the Brent index – will strongly affect US crude oil prices (West Texas Intermediate). It is true that the United States today is a minor net energy exporter; however, the macro-distribution of the shock will be negative. While a small group of energy companies will reap higher profits, households and businesses will take a giant price hit, prompting them to cut spending.

Faced with this dynamic, even an otherwise strong US economy will suffer a marked slowdown, tipping the balance towards a stagflationary growth recession. Tighter financial conditions and the resulting effects on business, consumer and investor confidence will exacerbate the negative macro fallout from the Russian invasion, both in the United States and globally.

In the same way, sanctions against Russia – no matter how large or limited, and no matter how necessary for future deterrence – will inevitably affect not only Russia but also the United States, the West and emerging markets. Likewise, the possibility of Russia responding to new Western sanctions with its own countermeasure cannot be ruled out: for example, by sharply reducing oil production to push global oil prices even higher. Such a move would represent a net benefit to Russia as long as the additional increase in oil prices is greater than the loss of oil exports. Putin knows that he can inflict asymmetric damage on Western economies and markets, because he has spent much of the last decade amassing war funds and creating a financial shield against additional economic sanctions.

A deep stagflationary shock is a nightmare scenario for central banks, who will be doomed if they react, and doomed if they don’t. In a context of rising inflation where central banks are already behind the curve, slower policy tightening could see inflation expectations de-anchoring rapidly, further exacerbating stagflation. But if central banks remain hawkish (or take a tougher stance), the looming recession will become more severe.

While central banks should aggressively deal with the return of inflation, they will most likely try to go off on a tangent, as they did in the 1970s. They will say that the problem is temporary, and that monetary policy cannot affect or undo a exogenous negative supply shock. When the moment of truth arrives, they will probably turn a blind eye and opt for a slower monetary adjustment so as not to generate an even more severe recession. This will further de-anchor inflation expectations.

Politicians, meanwhile, will try to cushion the negative supply shock. In the United States, policymakers will try to mitigate rising gasoline prices by dipping into their strategic oil reserves, and urging Saudi Arabia to increase oil production. But these measures will only have a limited effect, because widespread fears of future price increases will result in a global energy hoarding.

Nor can Western leaders rely on fiscal policy to offset the growth-damping effects of the stagflationary shock. On the one hand, the United States and many other advanced economies are running out of fiscal ammunition, having used all resources in response to the Covid-19 pandemic. More specifically, a fiscal (demand) stimulus is the wrong policy response to a stagflationary supply shock. While it may reduce the negative growth impact of the shock, it will add inflationary pressure. And if leaders rely on both fiscal and monetary policy to respond to the shock, the stagflationary consequences will become even more severe, due to the enhanced effect on inflation expectations.

It is tempting to think that the conflict between Russia and Ukraine will have only a minor and temporary economic and financial impact. After all, Russia represents barely 3% of the global economy (and Ukraine much less). But the Arab states that imposed an oil embargo in 1973, and the revolutionary Iran of 1979, accounted for an even smaller portion of global GDP than Russia does today.

Putin’s war will deal a crippling blow to global confidence at a time when the fragile recovery was already entering a period of uncertainty and rising inflationary pressures. The fallout from the Ukraine crisis will be anything but transitory.

The author

Emeritus Professor of Economics at New York University Stern School of Business, he is Chief Economist at Atlas Capital Team, an asset manager and fintech company that specializes in hedging against inflation and other risks.

Leave a Comment