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Europe must prepare for a wartime economy

Economic governance / COMMENTARY
Frederico Mollet , Georg Riekeles

Date: 24/03/2022
Russia’s invasion of Ukraine has fundamentally disrupted Europe’s security outlook. It also requires taking a hard look at our economy.

Pre-war, the EU was settling into consensus on a growth strategy defined by green and digital modernisation, industrial policy in response to geopolitical and technological competition, and a reform of its fiscal rules to provide space for investment.

Europe is now plunging into a precarious and uncertain environment where significant security pressures and economic trade-offs signal features of a wartime economy. Faced with the immediate economic shock, pressure to fund new expenditures, and a potential reconfiguration of the global economic system, the EU’s leaders must double down on EU solidarity mechanisms.

Is Europe ready?

The immediate shock of the Russo–Ukrainian war is already threatening to stall the EU’s burgeoning economic recovery, create a new supply chain crunch and threaten financial stability. For economist Nouriel Roubini, the war’s economic and financial consequences on Europe’s borders could be a “geopolitical depression” and return to 1970s-style stagflation.

The primary threat is the surge in energy prices, where Europe’s geopolitical naivety and lack of security-conscious policy has left it reliant on Russia. It is now being forced to take a much more interventionist approach on all critical inputs, including potential rationing, to secure industrial production and consumption. Despite the Common Agricultural Policy, which, for all its inefficiencies, aims to make Europe relatively food-secure, rising commodity prices also threaten to destabilise its entire Southern neighbourhood.

Meanwhile, Europe must accommodate the largest refugee flows since World War II, already over 3 million. At the cost of at least €10,000 per refugee, the response will require mobilising resources across EU society.

The dramatic shift in Europe’s security outlook is also forcing reinvestment in defence, a significant burden to public finances. Even if the conflict ends soon, the warfare economy will return for the foreseeable future – and will not be cheap. EU member states spent around 2.8% of GDP on defence in the 1970s and 1980s, compared to 1.6% in 2019.

In parallel to the end of the ‘peace dividend’, the EU faces unprecedented investment needs to avert catastrophic climate change and modernise its economy. Rising inflation will pressure the European Central Bank to roll back the stimulus that helped shield the balance sheets of fragile member states.

Finally, the West’s financial and trade sanctions on Russia will likely significantly reconfigure global economic relations. The severity of the sanctions represents an inflexion point in the steady weaponisation of the international economic system. Talk of decoupling and creating alternative financial systems have grown steadily, also against the backdrop of the pandemic. Deep-seated changes might finally materialise as this war changes how both the West and China see the world. Given the challenges, a serious contender to the dollar’s dominant role is unlikely. But we will now probably witness greater fragmentation and bifurcation in the existing system, particularly around trade.

Doubling down on EU solidarity mechanisms

At President Macron’s EU Versailles summit earlier this month, EU leaders recognised that this economic shock requires a coordinated European response, not a patchwork of national efforts. Yet they could not agree on the concrete measures, nor who pays for what.

As an immediate crisis response, the EU should prepare measures to wean our economies off Russian fossil fuels, agree on the steps to mitigate the economic shock and aid member states receiving the majority of Ukrainian refugees. A substantial proportion of the loan facility of the EU’s pandemic response, the Recovery and Resilience Facility, is still unused and could provide immediate support, particularly to frontline responders like Poland.

As of this week’s European Council meeting, leaders must also tackle the EU’s medium-term challenges, regardless of the outcome on the Ukrainian battlefield.

Firstly, the EU must double down on its investment push; for not only the twin green and digital transitions but also defence. Exempting certain national investments from the fiscal rules will not be enough. A less accommodative monetary policy will limit the ability of member states with high debt to invest further.

To contain duplication when increasing defence expenditure, commonly pooled defence investments at the EU level will be essential. Green and digital investments are public goods, and the green transition is clearly essential for security. This is why the EPC proposes a long-term central investment capacity funded through EU-level borrowing.

Secondly, the EU must construct a new social contract to protect the most vulnerable, spread the burden of these economic shocks fairly, and ensure long-term political support for new priorities. The increased investment for the green transition already implies a squeeze on consumption. The economic shock from the war will hit European living standards further.

The European Commission’s upcoming revision of the fiscal rules must avoid any sharp adjustment that would repeat the euro crisis of 2011-2013. In fact, other policy measures are needed. For example, European policymakers will have to allocate any new tax burden fairly and ensure that low-income households do not bear the cost of the sanctions.

Thirdly, the EU must seriously prepare for further geopolitical shocks and the reshaping of global economic relations around security concerns. Economic strategy can no longer assume benign conditions. This requires building more resilience into the European economic model, mitigating critical economic interdependencies, and exploring sources of growth that are less vulnerable to geopolitical shifts.

This process is already underway with respect to supply chains. However, the broader economic dependencies (e.g. Germany’s exports to China) and neighbourhood countries’ ability to weather shocks must also be considered.

Finally, in all this, Europe’s leaders must be ready to reassess the EU’s powers and remit of action. To avoid duplicating national initiatives and overburdening frontline states, and ensure the best use of resources, further institutional and operational capacities must be developed at the EU level.

These evolutions will, without doubt, revive profound political questions. The EU’s governance model, created for market integration, is not adept at delivering economic and military security. In so many ways, the current crisis is a decisive moment in European Union history.

Frederico Mollet is a Policy Analyst in the Europe’s Political Economy programme at the European Policy Centre. 

Georg Riekeles is an Associate Director and Head of the Europe’s Political Economy programme at the European Policy Centre.

The support the European Policy Centre receives for its ongoing operations, or specifically for its publications, does not constitute an endorsement of their contents, which reflect the views of the authors only. Supporters and partners cannot be held responsible for any use that may be made of the information contained therein.

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