The war between Russia and Ukraine means that there will be no return to normalcy for Europe

German Chancellor Olaf Scholz, French President Emmanuel Macron and Polish President Andrzej Duda will attend a press conference ahead of a meeting in the Weimar Triangle to discuss the ongoing Ukraine crisis in Berlin, Germany, on 8 February 2022.

Hannibal Hanschke | Reuters

The war in Ukraine and the subsequent economic sanctions imposed on Russia will cause far greater shifts to Europe’s economy and markets than previous crises such as the coronavirus pandemic, economists have said.

In light of Russia’s unprovoked invasion of Ukraine, European leaders have been forced to quickly accelerate plans to reduce their heavy dependence on Russian energy. The European Parliament on Thursday called for an immediate and total embargo on Russian oil, coal, nuclear fuel and gas.

However, this aggressive decoupling has a price for the European economy, which is driving already high inflation to record levels and threatening to undermine the recovery in production that began last year as economies sought to recover from the Covid-19 pandemic.

ING Head of Global Macro Research Carsten Brzeski noted last week that Europe is particularly vulnerable to losing international competitiveness as a result of the war.

“For the continent, the war is much more a game-changer than the pandemic has ever been. I’m talking not only in terms of security and defense policies, but especially about the whole economy,” Brzeski said.

“The eurozone is now experiencing the downside of its basic economic model, namely an export-oriented economy with a large industrial backbone and a greater dependence on energy imports.”

After benefiting from globalization and division of labor in recent decades, the eurozone now needs to increase its green transition and pursuit of energy autonomy, while increasing spending on defense, digitalisation and education. Brzeski characterized this as a challenge that “can and must actually succeed.”

“If and when that happens, Europe should be well positioned. But the pressure on household finances and incomes will remain enormous until it gets there. In the meantime, corporate profits will remain high,” he said.

“Europe is facing a humanitarian crisis and a significant economic transition. The war is taking place in the ‘bread basket’ of Europe, a key area for cereals and maize. Food prices will rise to unprecedented levels. Higher inflation in developed economies could be a matter of life and death. and death in developing economies. “

Brzeski concluded that financial markets were “misleading” as European equities try to rise higher, adding that “there is no return to any kind of normality of any kind right now.”

Debt sustainability concerns

This tectonic shift for the European and indeed global economy will put further pressure on central banks and governments caught between a rock and a hard place in juggling inflation and fiscal sustainability, economists acknowledge.

In a note on Thursday, BNP Paribas predicted that faster efforts to decarbonise, higher public spending and debt, more intense headwinds to globalization and higher inflationary pressures would be a persistent theme.

“This background presents central banks with a more challenging environment in which to pursue policy and keep inflation on target, not only reducing their ability to commit to a particular policy, but making policy mistakes more likely,” said BNP Pariba’s senior European economist. Spyros Andreopoulos.

He also noted that raising interest rates to curb inflation will ultimately make life difficult for financial authorities.

“While this is not an immediate concern, not least because governments have generally extended the average maturity of their debt in the low interest rate years, a higher interest rate environment may also change the fiscal calculation. In the end, concerns about debt sustainability may re-emerge,” he said. Andreopoulos.

Low inflation throughout the recent history of the eurozone meant that the European Central Bank was never forced to choose between fiscal sustainability and the pursuit of its inflation targets, as low inflation necessitated the accommodative monetary policy that helped with fiscal sustainability.

“Politically, the ECB was able – in our opinion convincingly – to derive accusations that it helped governments by pointing to low inflation outcomes,” Andreopoulos said.

“This time, the ECB needs to tighten policy to curb inflation in the face of even higher public debt, a legacy of the pandemic and continued pressure on public money.”

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