Alexander Zanzer: Economics of War
War economy refers in general to an economy of a country at war. But in the current globalized economy, trade and financial interdependence, nobody can hide from the repercussions. The basic principles remain the same, but expanded to almost every country in the world.
A war economy prioritizes the production of goods and services for the defense industry, while seeking to strengthen the economy as a whole. The unprecedented economic sanctions on the Russian Federation have distorted global trade and made apparent its weaknesses. Self-reliance and energy independence are the two sides of the same coin. Any military conflict brings two uncertainties into equation: the uncertain timing of the end of the conflict and the result itself as well as the fear for both of them.
Instability is the biggest enemy of the economy and fear makes financial markets work irrationally.
Physical barriers during a conflict make supply lines unreliable and fear contributes to hoarding. The direct result of this is inflation. A war following a pandemic has not been seen since WWI when the Spanish flu entangled with war. Government spending in every country increased already significantly to combat the economic effects of covid-19. Now, all the governments will spend even more to increase defense spending and take care of millions of refugees.
In these uncertain times, making predictions is not a sinecure. Economists believe that a new world order will emerge with rival power blocs.
It is interesting that major emerging countries such as China and India abstained from a vote in the UN Security Council to condemn Russia. This points to the risk of an increasingly fragmented world market for goods. It is not difficult to imagine a world with a bloc around China and one around the U.S. and Europe, a development that fits in with the deglobalization that seems to be underway. But you cannot apply blindly economic theory in an unseen situation. Nothing is black and white. Economics is a human science.
Theory dictates that deglobalization leads to less growth. The raw material shock makes energy and all sorts of metals indeed considerably more expensive. But if deglobalization leads to smart investments in high-tech manufacturing industry and in infrastructure, the impact on growth should not be negative. What still can make theory a reality, is the combination of higher inflation, more investments and more demand for money, and at the same time less savings will result in higher interest rates. Keeping interest rates low as they were to stimulate the economy, is no longer an option. Central bankers will have later on more room to lower the rates if another recession emerges.
Because the war is physically in Europe, the risk for recession situates for the most also here. The European economy will start to decline from the second quarter already as result of the higher energy prices. But this should not last for the entire year. First, the war in Ukraine could be over till the summer. Secondly, European household saved a lot during the pandemic and can use it to stimulate the economy.
The U.S. economy is on the other hand clearly more overheated than that of Europe, with the labor market experiencing a historically large gap between the number of jobs and vacancies and the number of people available. U.S. wage growth of 5 to 6 percent is not Instability sustainable in view of the inflation target of 2 percent. Therefore, interest rate hikes should help cool the demand.
We have to admit that the shadow of stagflation is descending rapidly to dominate predictions. We already have high inflation and we expect a slowdown in growth that could lead to a recession. That is the strict definition of stagflation, but it is possible that high unemployment is added to the definition, even if Europe today has its lowest unemployment rate ever. Governmental fiscal stimuli can soften the shock. European governments try to compensate high energy prices through lower VAT and other social measures.
A crisis brings people and governments closer together. Europe finally decided to issue European debt which makes the European project more realistically on the long term.
Concerning China, the growth could be reduced to 4.5 to 5%. China imports energy which makes inflation in China more pronounced and reduces its competitiveness. The real estate market which contributed a lot (1.5%) to the growth in China has signs of a bubble and the government will intervene. The zero-covid policy in China makes trade also extremely difficult.
So with all this uncertainty and even negativity, bonds are not really recommended and investments in raw materials and mining could be more profitable. Even tourism and entertainment have better prospects due to a will to revive past feelings after two years of travel bans due to the pandemic. Real estate also sees no decline because building materials increase in price and there is also scarcity of materials and labor on the market. Higher interest rates play a negative factor, but when the demand is higher than the offer, prices still go up.
It is interesting to note that President Zelensky found time to sign a tax reform bill and reduced corporate taxation to an incredibly low 2%. Yes, after destruction, rebuilding is the main priority. Attracting investments into a former war zone will not be easy. The countries in the region will also suffer from military and economic instability and will have to follow somehow by lowering taxation. Some of them are in the European Union and will try to attract investment even more aggressively than they did till now.