The Long-lasting Economic Shock of War

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The Long-lasting Economic Shock of War

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Bibliographic details

• Authors: KENNETH ROGOFF
• Published: April 11, 2022

Immediate humanitarian and global economic impacts

• War in Ukraine described as "an unmitigated catastrophe for global peace and particularly for peace in Europe."
• Ukraine in a state of "severe economic distress" with destruction of physical capital, millions fleeing, and "countless thousands" killed or maimed.
• COVID-19 pandemic raised the number of people living in extreme poverty by roughly 100 million to nearly 700 million; "a significant share live in conflict regions."
• The war compounds preexisting adverse global trends: rising inflation, extreme poverty, increasing food insecurity, deglobalization, and worsening environmental degradation.
• Russia and Ukraine combined accounted for a quarter of global wheat exports prior to the conflict.
• Russia is a major supplier of fossil fuels, especially to Europe; disruptions to these commodity supplies are driving up prices.

Inflation dynamics and monetary policy

• Post-pandemic inflation was already at "multi-decade highs" in most of the world; the war exacerbates fuel and food shortages and inflation.
• Excessive and prolonged peacetime macroeconomic stimulus contributed to inflation; example cited for the United States:
  • $900 billion fiscal stimulus at the end of 2020 followed by a $1.7 trillion package in March 2021.
• Across advanced economies, "more than half (including the United States and the euro area) had inflation rates of over 5 percent even before hostilities."
• Federal Reserve expectations and market indicators:
  • Fed officials predict raising the federal funds rate to 2.75 percent, from near zero in January.
  • The first hike of 0.25 percent already came in March.
  • Fed expects a fast-paced reduction in the size of its massive balance sheet.
  • As of the first week of April, five-year forward inflation expectations stood at "just under 2.4 percent."
• Markets expect interest rate hikes to be transitory, with the Treasury yield curve inverting (short rates higher than long rates).
• Risks highlighted:
  • Prolonged high inflation could erode central bank credibility.
  • Wage increases currently trail inflation in many countries, but persistent inflation raises the risk of destabilization.
  • Public and private debt levels are "vastly higher" than in the 1980s tightening cycle; sharp monetary tightening could destabilize debt dynamics.

Fiscal policy and defense spending implications

• Short-term fiscal implications of the Ukraine war for advanced economies are "quite modest" compared with pandemic-era stimulus programs.
• "Cumulative long-term effects of a fading peace dividend" could be substantial.
• Europe could "easily end up raising defense spending by 1 percent of GDP annually, if not more."
• The resulting costs could exceed the "ambitious, €807 billion NextGenerationEU stimulus during the pandemic."
• Rebuilding Ukraine could "amount to €100 billion or more."
• Historical U.S. context: since 1989, the United States "has been able to shrink its military budget by 3 percent of GDP."
  • That 3 percent "was more than enough to cover all of today’s government spending on nondefense consumption and investment."
• Expectation that the U.S. will likely raise military spending by a similar amount to Europe over the next few years; Biden administration’s original goal of shifting military spending to social programs is "already on hold."
• Global reevaluation of defense needs driven by events such as the chaotic US retreat from Afghanistan and the war in Ukraine.

Deglobalization risks and long-term economic effects

• Deglobalization risks have risen since the invasion of Ukraine; pandemic-era discussions already emphasized supply-chain resilience and less reliance on imports for critical goods.
• Exit from Asia’s zero-COVID policies is increasing supply disruptions, illustrating "temporary deglobalization."
• Russia is likely to be isolated for an extended period; a larger shock would occur if trade between advanced economies and China drops.
• Canonical quantitative trade model estimates cited:
  • About 2–3 percent lower GDP for the United States under substantial deglobalization.
  • Perhaps 3–4 percent lower GDP for China.
• These baseline estimates depend on many assumptions, including substitution of domestic for imported goods and the ability to trade with other partners.
• Additional considerations:
  • Higher local markups and less "creative destruction" could make costs significantly higher.
  • Globalization may have dynamic effects not captured by existing models, including effects on institutional development.
  • Deglobalization will likely hit some sectors much harder than others, potentially amplifying aggregate effects.
• Argument that globalization was a key factor in disinflation during the 1990s and 2000s; deglobalization could exacerbate upward inflation pressures.
• Reference to demographic pressures: Charles Goodhart and Manoj Pradhan argue that adverse demographics in east Asia and eastern Europe will increase global price pressures; similar themes were discussed in the author’s 2003 paper, “Globalization and Global Disinflation.”

Policy lessons and recommendations

• Policymakers must incorporate resilience into monetary and fiscal policy responses to major macroeconomic shocks, not just adopt "maximalism."
• Key trade-offs to consider:
  • Central bankers must balance the risk of losing the inflation anchor against the risk of causing a major recession.
  • Fiscal authorities must re-evaluate priorities in light of higher defense spending needs and a fading peace dividend.
• Implicit policy priorities highlighted:
  • Preserve central bank credibility to prevent persistent high inflation.
  • Manage public and private debt vulnerabilities when considering the pace and extent of monetary tightening.
  • Prepare for potentially higher and more persistent inflation pressures if deglobalization and adverse demographics persist.
  • Anticipate reallocations of fiscal resources toward defense in advanced economies and the fiscal cost of rebuilding in conflict-affected regions.

KENNETH ROGOFF, "The Long-lasting Economic Shock of War," F&D Magazine