Russia’s invasion of Ukraine could upend fiscal and monetary policy in advanced economies
KENNETH ROGOFF is Maurits C. Boas Professor of Economics at Harvard University and a former chief economist and Research Department director at the IMF.
Opinions expressed in articles and other materials are those of the authors; they do not necessarily reflect IMF policy.
Russia’s invasion of Ukraine is an unmitigated catastrophe for global peace and particularly for peace in Europe. But the war also greatly compounds a number of preexisting adverse global economic trends, including rising inflation, extreme poverty, increasing food insecurity, deglobalization, and worsening environmental degradation. In addition, with an apparent end to the peace dividend that has long helped finance higher social expenditures, rebalancing fiscal priorities could prove quite challenging even in advanced economies.
To begin by stating the obvious, war-torn Ukraine is in a state of severe economic distress. In addition to the destruction of physical capital, millions have fled the country, and countless thousands have been killed or maimed. This comes on top of a generalized rise in economic distress around the world as a result of the COVID-19 pandemic. According to the World Bank, the number of people living in extreme poverty rose by roughly 100 million to nearly 700 million; a significant share live in conflict regions.
For the global economy, fuel and food shortages caused by the war are exacerbating post-pandemic inflation that had already reached multi-decade highs in most of the world. To say that the causes are well known would be an exaggeration given that the ultralow inflation of the 2010s still puzzles academic macroeconomists. But the main drivers are apparent. First, governments and central banks were slow to unwind unprecedented peacetime macroeconomic stimulus. Certainly, record early stimulus greatly helped cushion the first stage of the pandemic, but in some cases, it persisted too long and proved excessive after the unexpectedly sharp rebound in advanced economies and some emerging markets. In the United States, in particular, the combination of a $900 billion fiscal stimulus at the end of 2020 followed by a $1.7 trillion package in March 2021 proved too much, too late.
Supply chain disruptions have also been a major contributing factor to inflation, although some of the strain on supply should really be traced to the sudden surge in demand. Across advanced economies, more than half (including the United States and the euro area) had inflation rates of over 5 percent even before hostilities, so that the war made an already difficult situation worse. Prior to the conflict, Russia and Ukraine combined accounted for a quarter of global wheat exports, and Russia is a major supplier of fossil fuels, especially to Europe. Disruptions to supplies of these commodities are driving up prices.
How much central banks will ultimately have to raise interest rates, and how long they will stay up, is a major question. The central prediction of Federal Reserve officials is that they will take the federal funds rate up to 2.75 percent, from near zero in January. The first hike of 0.25 percent already came in March, and the Fed also expects a fast-paced reduction in the size of its massive balance sheet. Markets seem to have great confidence that the combined effects of these actions will be enough, and that there will be a smooth landing for the overheated economy. Notably, as of the first week of April, five-year forward inflation expectations stood at just under 2.4 percent, no higher than in early February 2018 and almost half a percentage point lower than a decade earlier. Moreover, market expectations are that the interest rate hikes will be distinctly transitory, with the Treasury yield curve “inverting,” so that short rates are higher than long rates.
But this sanguine view understates the significant risk that prolonged high inflation will be destabilizing. True, for the moment, wage increases trail inflation in many countries, even in tight labor markets, suggesting that central bank credibility remains strong, even outside financial markets. But as high inflation persists, there is an acute risk that central bank credibility will erode, and it could prove difficult to put the inflation genie back in the bottle.
Central bankers are keenly aware of the risk of losing their inflation anchor, but they also need to worry about causing a major recession. Another challenge is that public and private debt levels are vastly higher today than they were during the last advanced economy tightening cycle in the 1980s, and a sharp monetary tightening could destabilize debt dynamics, which have otherwise been usually benign for the past decade.
For fiscal policy, the short-term implications of the Ukraine war for advanced economies are quite modest compared with those of pandemic-era stimulus programs. However, the cumulative long-term effects of a fading peace dividend could prove larger than most governments have so far acknowledged. Europe, for example, could easily end up raising defense spending by 1 percent of GDP annually, if not more. If that happens, the resulting costs will likely exceed even the ambitious, €807 billion NextGenerationEU stimulus during the pandemic. And that does not count Europe’s eventual contribution to rebuilding Ukraine, which could amount to €100 billion or more.
Since the fall of the Berlin Wall in 1989, the United States has been able to shrink its military budget by 3 percent of GDP, more than enough to cover all of today’s government spending on nondefense consumption and investment. The Biden administration’s original goal of further shifting military spending to social programs is already on hold, and it is a fair guess that over the next few years, the United States will end up raising military spending by a similar amount to Europe. Meanwhile, the chaotic US retreat from Afghanistan and the horrific spectacle of war in Ukraine have many other countries reevaluating their defense needs.
Risks of deglobalization have also risen markedly since the invasion of Ukraine. Already after the start of the pandemic, there was much discussion of making supply chains more resilient and trying to rely less on imports for public health necessities such as vaccine and antibiotic production, not to mention the semiconductors that are the foundation of the digital economy. The exit from Asia’s zero-COVID policies is still increasing supply disruptions, providing a glimpse of what temporary deglobalization could look like.
Russia, of course, looks set to be isolated for an extended period, but the real hit to globalization will happen if trade between advanced economies and China also drops, which is unfortunately possible in some scenarios. A major realignment of the global economy can hardly be good for geopolitical stability. Since Montesquieu, political economists have argued that countries that trade with each other are less likely to go to war, with the main modern nuance being that indirect trade through common partners and networks also helps.
In the near term, deglobalization would surely be a huge negative shock for the world economy. Whether long-term effects could be as severe is less well understood. The substantial trade literature on this topic yields surprisingly (to me) small estimates. Canonical quantitative trade models yield an estimate of about 2–3 percent lower GDP for the United States and perhaps 3–4 percent for China. The baseline numbers are similarly modest for financial globalization.
Importantly, these rough guesses depend on myriad assumptions, including how easily countries can substitute domestic for imported goods or trade with other partners. Moreover, to the extent that trade deglobalization leads to higher markups by local monopoly suppliers, and less “creative destruction” in the economy, the costs can be significantly higher. And globalization may have dynamic effects that existing models do not take into account, not to mention positive effects on a country’s institutional development. Also, just as there can be big losers from globalization even if the winners gain much more, the effects of deglobalization are likely to hit some sectors much harder than others, which can in turn amplify the aggregate effects.
Returning to inflation, there is a strong case to be made that globalization is the secret sauce that made the job of bringing down inflation immensely easier in the 1990s and 2000s, so that deglobalization could easily exacerbate upward inflation pressures for an extended period. Recently, Charles Goodhart and Manoj Pradhan forcefully argued that adverse demographics in east Asia and eastern Europe will persistently increase global price pressures, just as the rise of China has been a disinflationary force. I made a similar argument in my 2003 Jackson Hole conference paper, “Globalization and Global Disinflation,” saying that while the advent of central bank independence helped, it cannot be given all the credit for the decline in inflation in the 1980s and 1990s.
Perhaps the most important macroeconomic lesson today is that in crafting responses to the latest major macroeconomic shock, whether it be the financial crisis, the pandemic, or now war in Europe, policymakers (not to mention academic economists) must remember that although things usually get better after a catastrophic shock, they can also get much worse. Thus monetary and fiscal policy need to incorporate resilience, and not just the maximalism that has become fashionable of late.
