Ukraine could be more of a game-changer for Europe than Covid-19
Say goodbye to peace dividends
Europe has had a long period of peace, which makes it rather lax when it comes to his own safety is concerned. Few European NATO members actually meet the 2% of GDP target for defense spending. Even when former US President Donald Trump made it clear that Europe could not continue freeriding, relying heavily on the US for its defense, little changed. However, the war in Ukraine, only 1600 km from Brussels, the European capital, has clearly shown that Europe must mobilize to guarantee its own security. Several countries, notably Germany, have already announced a significant increase in defense spending. But this is money that could otherwise be spent on more productive investments, so the long-term growth potential in these countries will be impacted. Peace dividends can no longer be counted on.
David Ricardo upside down
During the Covid-19 pandemic, much has been said about diversifying supply chains to avoid supply chain disruptions. At the same time, management reviews were teeming with analyzes of inventory management evolving from “Just in time” to “Just in case”. With the current uncertainty created by the war in Ukraine, which has an impact on the supply of raw materials and semi-finished products in a large number of sectors, the urge to build up stocks could be even stronger. But a higher inventory-to-sales ratio comes at a cost, which will ultimately make the end product more expensive.
A big difference between the pandemic and the war in Ukraine is that supply chains are no longer “just” disrupted but could be destroyed for good. Containers from Asia will return to Europe at some point. Microchips will be produced and introduced in Europe at some point. But products or goods from or via Russia to Europe are highly unlikely. This fear of running out of crucial inputs in a more uncertain world could even be an argument in favor of relocation; bring the production of critical inputs closer to home. While relocation is likely to be welcomed and subsidized by politicians and approved by public opinion, it of course completely ignores the welfare gains of the international division of labor (David Ricardo’s Theories in Economics 101).
There was a reason these industries moved overseas in the past. Bringing them back, when we have no comparative advantage, will not increase our growth potential and will instead lead to higher prices.
The European Commission has already announced plans to reduce its energy dependence on Russia. If accelerating the development of renewable energies is probably a good thing for the European economy, it will all the same have a cost in the transition period, especially if Europe were to boycott one of the main exporters of fossil fuels. Substitutes for Russian gas are likely to be more expensive or require additional investment, crowding out other productive investments. Energy-intensive sectors are already struggling and this may not improve much in the years to come.
All in all, the war in Ukraine has completely reshuffled the cards in terms of security, supply chains and energy supplies. As a result, Europe will experience a strong acceleration of two major trends that have already started to manifest themselves in recent years: decarbonisation and de-globalization – as well as an increase in defense spending. Prioritizing these trends will come at a cost: higher public debt, higher inflation, and lower economic growth. The nature of the economic model of the euro zone, ie a very open economy with a strong energy dependence, is an obvious handicap in the years to come.
The only silver lining is that once the required transition is successful, the Eurozone could lead in renewable technologies and energy. However, before the Eurozone approaches such a scenario, it will first have to deal with reduced growth potential and a higher inflation outlook.
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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.