Russia’s war is testing Europe’s moral courage as much as its economy

How should the EU deal with the economic costs of Vladimir Putin’s war? This is not the same as minimizing these costs. It is a war on which the future of Europe will depend, perhaps on democracy itself. At such times, the goal of economic policy is to support the war effort. Policy should seek to maximize the costs for the aggressor relative to those for the EU, especially for its most vulnerable citizens. How should this be done?

If we want to think about this question, we need a framework for analysis. Olivier Blanchard, former chief economist of the IMF, and Jean Pisani-Ferry specify this in a recent article. They list three challenges: first, “how best to use sanctions to deter Russia, while limiting the negative effects on the EU economy”; second, how to deal with the declines in real incomes that result from the rising cost of energy imports; and, third, how to deal with the rise in inflation caused by rising energy and food prices, which added to the post-Covid inflation spike. Needless to say, such an analysis is tentative. In times of war, the future is even more uncertain than usual. (See graphics.)

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Regarding the impact of the sanctions on Russia, consider a recent comment from Rystad Energy: “Despite severe oil production cuts expected in Russia this year, tax revenues will rise dramatically to more than $180 billion due to the surge in oil prices. . . This is 45% and 181% more than in 2021 and 2020, respectively. This is not to deny the damage caused by the sanctions: the IMF predicts that the Russian economy will contract by 8.5% this year. But that means higher prices more than offset volume reductions. Consumers are hurting, but they are also funding the invasion of Ukraine. It is bad policy.

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The objective must at least be to reduce Russia’s export revenues, not to increase them. A number of economists have pondered what this might require. Seven points emerge from their analyses. First, the EU’s vulnerability vis-à-vis Russia, but also its power over it, is greater in gas than in oil, because gas is more dependent on fixed infrastructure. This makes it more difficult for Russia to diversify sales (but also purchases by the EU). Second, the most effective way to reduce Russia’s revenue is not an embargo but a punitive tax or tariff, which should transfer Putin’s “energy rent” to consumers. Third, the imposition of tariffs would generate revenue that could be used to help those currently suffering from real income losses. Fourth, a tax imposed by the EU alone on Russian exports would yield more gas than oil, due to the greater difficulty in diversifying gas exports. Fifth, trade sanctions would be more effective the higher the number of participating countries. Sixth, oil sanctions could be extended by imposing sanctions on shipping. Finally, the cost of such measures for Russia would be a significant multiple of their costs for the EU and its allies.

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Achieving consensus on effective measures is difficult, but crucial. A way must be found to transfer more of Russia’s export earnings to consumer countries. Yet, whatever we do about it, there will be significant costs for the wealthy importing countries of the war: increased defense spending; increased spending on energy infrastructure; aid to refugees; and, above all, substantial support for hard-hit developing countries.

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Inevitably, the main political question will be how to cushion the blow to domestic consumers. Should this be done through energy subsidies, transfer payments or price controls? Much of the answer depends on the sanctions regime adopted. But the general point is that subsidies will tend to offset sanctions by increasing consumption rather than reducing it. It would be better to increase transfers of purchasing power to vulnerable households, leaving it up to them to decide how to spend it. Oil price controls were a disaster in the 1970s. I see no good reason why they should do any better now. If we want to limit exceptional profits, it is better to tax them.

Billion cm line graph showing that the invasion is expected to permanently reduce Russian gas production

How, Blanchard and Pisani-Ferry also ask, should transfers or other spending measures be financed? Given that a war is a short-term emergency, the case for additional government borrowing is strong. Moreover, given current long-term interest rates (still very low) and projected increases in nominal gross domestic product (boosted by inflation), additional debt would be affordable.

The question of monetary policy then arises. The impact of war is to reinforce upward pressures on prices, risking an inflationary spiral in wages and prices, while simultaneously weakening demand as real incomes are squeezed. Blanchard and Pisani-Ferry suggest that these two effects cancel each other out. In this case, they argue, monetary policy should stay on the tightening path charted before the Russian invasion. But they also suggest that fiscal measures could aim to reduce price inflation, thereby reducing the risks of a wage-price spiral. They also suggest that such tax measures could be integrated directly into the wage negotiation process. I’m skeptical. Still, it could work in northern Europe.

Line chart of Mn barrels per day showing that the invasion is expected to permanently reduce Russian oil production

The conclusion that I draw from these analyzes is that the war is a major economic shock, but that it is much more a political and moral shock. A brutal conflict has come to Europe of a kind not seen since World War II, and even where some of its worst atrocities have occurred. For Germany in particular, this is a time of challenge and opportunity. The challenge is to defend the liberal civilization of Europe. The occasion is for historical redemption. Russia must not win. That’s what matters most. There will indeed be pain. But it must be supported for a much greater cause.

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