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Thursday, February 24, 2022

War In Europe

The unprovoked invasion of Ukraine by Russia is the first major cross-border war in Europe since the end of World War II. To what extent the West does not shrug this off, we may be seeing a reversion towards Cold War policies. The problem for Western leaders is that their governing elites have incoherent views towards Russia, and it is unclear how much this will change.

I have seen a great many takes on the situation, using pre-1945 analogies. Those analogies are moot, the advent of nuclear weapons has changed diplomacy and war fighting doctrines. A basic principle of the Cold War was that nuclear powers did not have regular troops facing each other in a conflict, proxy troops were used, with perhaps a scattering of “advisors.” This will not change. The implication is that if fighting were to continue, it would be in the form of an insurgency. Such a war would have extremely grim implications for the Ukrainian populace. This means that any reaction from the West will have to be economic — but what tools are available?

At the time of writing, energy prices are spiking, which is what one would expect. It seems extremely likely that Russian commodity exports will be exported via China, so in the longer term, we will just see a redirection of trade flows. In the shorter term, such re-routing cannot be immediately achieved, so supplies going into Europe would be constricted.

Another energy price spike will yet again extend the period of high inflation. Although I was on “team transitory,” I have to accept that “transitory” is an increasingly bad description of the situation. However, an energy price spike needed to ration supply implies that quantities have to fall — that is, the main importers of Russian commodities will face a contraction in real energy consumption, and likely, GDP.

People want to label this “stagflation,” which I think is misleading. If a recession occurs, it would just be a mechanical reaction to a disruption in energy supplies, which is a fairly easily understood possibility in industrial capitalism.

The question is: do policymakers lean into a slowdown by loosening fiscal policy? Government spending that is not tied to a particular price (unlike a Job Guarantee, where the wage is fixed) that is being used to try to preserve aggregate activity in the face of a supply constriction is likely going to be inflationary. Given that we are already seeing extremist activity capitalising on discontent, doing nothing in the face of a recession poses risks. Unlike mainstream models, policymakers do not face simple trade-offs that can be solved in an optimal fashion.

So long as a financial crisis is avoided in the coming weeks (I have no idea), a 25 basis point rate hike by the Federal Reserve seems likely. A steady path of 25 basis point rate hikes is already priced in, and a few such hikes is not going to have any measurable effect on the economy. All they need to do is slow down the pace of hikes if activity data looks shakier. The belief that they would hike by 50 basis points was always a stretch, and there is no longer an justification for such a step. The only reason to do so was for the Fed to try to assert dominance and inject some risk premia into asset markets; the invasion did that already. Although it might appear prudent to delay a hike, so long as the financial system is functioning, it could easily be taken as a hint that the Fed thinks that the situation is worse than the market believes.

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(c) Brian Romanchuk 2022

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