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The economic consequences of war

2022-03-31 at 12:16 Timo Löyttyniemi

Europe does not need war; we are simply too civilized to fight. It turns out that the situation in Europe was not as good as we wanted to believe. Now the war has been here. At the beginning of February, I myself did not expect a war to break out. I was wrong but also very much right. I was wrong in that a war did break out. I was right in that the disadvantages of the war have proved to outweigh the benefits for Russia. Russia should not have gone to war. There was no justification or reason for it, although it may be futile to look for any rational motive.
 

War and the markets

Each of us has had to dig for evidence of the impact of war on the economy and markets. Generally speaking, it would seem that when the conflict or war breaks out, the stock market falls, to recover slowly in due course. When uncertainty reaches its peak, the markets suffer but tend to recover when the war situation clears up. Browsing the financial literature, the heading "the war puzzle" seeks to illustrate some odd market behaviour at times of war.

But each war is different. An apparent winner may lose ground with time, and peace may be restored quickly or slowly. It is often impossible to foresee these developments at the outset. Russia and Ukraine need to agree on a cease-fire, to be followed by peace and the normalisation of relations between Russia and the West. It will probably be a long and winding road.
 

The power of sanctions

Many were taken by surprise by the uniformity, speed and force of the sanctions imposed by the West.  The list of sanctions is long and possibly growing. The war has united democratic countries, the NATO, Europe and the EU. We understand why we exist and what we are called upon to protect. After all, democracy may still be the best of all flawed systems of government, as some wise men have said. Winston Churchill put it as follows: “Democracy is the worst form of government, except for all the others.”
 

Will Russia collapse?

Western sanctions on Russia will have both short-term and long-term economic effects. Because of the low transparency of the Russian economy, it is hard to see what exactly is going on, especially in times of crisis. However, it is easy to predict that the sanctions will have specific effects on economic growth, potential effects on financial stability and probable effects on inflation.

At the heart of economic growth lies business activity, which is directly impacted by the sanctions. Exports from and imports into Russia will be complicated, there will be a shortage of goods, prices will rise, and employment will fall. In the financial markets, the assets of Russian banks have been frozen to reflect the situation on 18 February 2022, while the central bank is applying lax criteria in providing as much funding as the financial sector needs.

The rouble-based economy may continue to function just as long as businesses and banks are allowed to operate. If things come to a head, the government, or agencies close to the government, may offer funding to underpin the balance sheets of banks and companies. Accordingly, we need to monitor national debt and the central bank’s balance sheet. Concerns over a galloping inflation rate are genuine, and we may see individual companies and banks facing overwhelming problems. Whether this will escalate into a major crisis, panic or recession, will depend on Russia's ability to deal with the problems as they arise. It is a harrowing task with no precedents.

With time, weak economic growth will squeeze households, businesses and governments. A weak economy is likely to give rise to social problems and this likelihood will only increase over time. The situation will be further complicated by the lack of key technologies.
 

Energy exports the key issue

The fate of the Russian economy depends on energy exports to Europe. Hence, energy is the most central – as well as the most difficult – issue facing Western decision-makers. If it remains unresolved, the effect of sanctions will be eroded. Continued Russian energy exports, possibly even at a high price level, will only serve to finance the war. Moreover, the revenues from energy also help Russia to maintain an adequate currency reserve despite the sanctions. Consequently, a solution to the energy equation plays a key role in the efforts to dissuade Russia and stop the war.
 

The West possesses strong and diversified financial buffers

Western democracies are based on decentralised decision-making. One of the advantages enjoyed by the market economy is that companies and individuals are able to adapt quickly to changing circumstances. Companies, banks and governments have ample buffers to absorb the spill-over effects of sanctions on their own soil. While problems may arise in certain quarters, they are not likely to create major difficulties for other players.

Today’s buzzword is stagflation, a situation that arises when slow growth coincides with high inflation. The high inflation rate that we have seen in recent months will continue at the same time as central banks are struggling with the timing of the measures to tighten monetary policy. Interest rates will follow inflation in one way or another, at least if inflation remains permanent.

Economic growth in Europe will deteriorate this year, but investment needs and prospects will improve. Investments in the green transition will grow and accelerate, defence spending will increase significantly, and the reconstruction of Ukraine will trigger a new wave of investments when the time comes.

High energy costs will result in a quick shift to renewable energy sources. Wind and solar power and nuclear power, in one form or another, will provide the solution. The surge of investments over a short period of time will be massive. The green transition is already underway, propelled by high oil and natural gas prices, while Russia's behaviour is making decision-making swift and easy.
 

In conclusion

The human tragedy brought about by the war is great. War in Europe makes no sense whatsoever. The impact of the war and subsequent sanctions will be felt in Russia while its economy staggers towards an unknown future. At the same time, the spill-over effects of the sanctions are also being reflected elsewhere in Europe. The market economy is likely to prove itself while the role of governments will grow in many areas and the position of the EU will be strengthened.
 

The writer is VER's CEO Timo Löyttyniemi.

TLö blogi 2020

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