The Russia-Ukraine war is bound to deliver an economic blow to the European Union (EU) and its member states and to require a rethink of a range of economic policies.
The EU has responded with exceptional unity, resolve, and speed to the war, the influx of refugees, and the concern about disruption of energy supplies. But Russia's invasion of Ukraine will leave a long-lasting legacy shaping Europe's priorities and policy choices for years and decades to come.
The main immediate risks to the European economy arise from the supply shock triggered by the increase in oil and gas prices, from Europe's dependence on Russian energy, and from the impact of geopolitical threats on household confidence and investor sentiment. Europe also has the duty to welcome millions of war refugees and provide them with emergency assistance. In 2022 already, the direct budgetary impact of the corresponding decisions could amount to €175 billion, or 1¼ percent of EU GDP, if not more. In the longer term, the EU confronts the necessity to boost defense spending in response to aggravated security threats and to rethink its energy system.
This blog post assesses the fallout from higher energy prices, the need to reduce reliance on Russian oil and especially gas, the refugee crisis, and the inevitable defense buildup. The upshot is that policymakers in Europe are forced to pivot away from the expected post-COVID-19 normalization and to join forces to tackle new emergencies. Longer term, they face a wholesale rethink of Europe's policy system that will affect budgetary priorities, principles for macroeconomic policies and market regulation, and the division of tasks between the EU and the member states.
This analysis leaves out many other channels, from the confidence shock to ripple effects on agricultural supplies and commodities markets. It also does not address the broader, and critical, question of the potential fragmentation of the global economy that could result from the realization that the "weaponization of interdependence" is no longer a matter for mere speculation.
Orders of magnitude provided in this blog post are extremely rough. They may prove wrong by a significant margin. The aim here is only to contribute to a discussion that must develop and will certainly result in much more accurate assessments.
1. Responding to a new supply shock
On the eve of Russia's attack on Ukraine, the EU was already coping with a sharp deterioration of its terms of trade and with rising inflation, most of which was attributable to the price of imported energy. Although recovery from the pandemic shock is still incomplete and inflationary expectations are still somewhat below target, the European Central Bank (ECB) was facing a difficult balancing act between looking through temporary price hikes and addressing the inflationary threats. The confrontation with Russia implies a more pronounced and longer-lasting shock, which will seriously aggravate the prevailing policy dilemma.
The standard rulebook when facing a commodity price shock is that the central bank should essentially tackle the second-round effects and avoid a potential escalation of inflationary expectations. It should not embark on a futile attempt to control the immediate impact of price rises on aggregate inflation (on which increases in the policy rate have very limited bearing, if any), and it should accommodate permanent relative price changes.
In the very short term, the ECB is likely to wait and see until it takes a decision. But it may soon be forced to make a politically difficult choice: tolerating headline inflation remaining above target for longer or weakening the economy in the midst of a geopolitical confrontation. Its action will be further complicated by the risk of a widening of the spreads on government bond markets.
As argued by Olivier Blanchard, in this situation a case can be made for a partial fiscal offset of the shock. In most EU countries, initiatives have been taken already. Governments have introduced a raft of measures to contain the rise in prices and to support vulnerable households.
But the question is whether governments should rely primarily on transfers (which can be targeted but do not contribute to limiting inflation) or should also intervene through across-the-board tax cuts and administered price controls (which affect the consumer price index and therefore facilitate the task of the central bank, but are much more costly budgetwise and obliterate the price signal). In some EU countries at least, both types of measures are being implemented.
The war context will push governments toward implementing more direct price interventions than they would normally consider. An important issue is whether the EU will revise the mechanism that leads to pricing electricity on the basis of the cost of the marginal energy source, which acts as a powerful transmitter of shocks to the price of gas and creates massive rents for electricity producers. Some governments, for example, in Spain, have introduced clawbacks. Others, like in France, have capped price rises. Whatever the discussion on the intrinsic merits of the electricity pricing system in place in the EU, there is now a case for a rethink in a context in which inflation acceleration is a major concern. Unplugging this mechanism temporarily (for, say, six months) would alleviate pressing macroeconomic policy tradeoffs.
More generally, the war will inevitably lead the EU and national states to depart from standard policy assignments. It will prompt further steps into a messy world in which governments interfere with markets for security reasons and in which monetary and fiscal policies are strongly interdependent. Coordination, rather than the clarity of the policy framework, will be the new motto. The COVID-19 crisis has already resulted in a move in this direction. Hopes for normalization are most likely to be frustrated.
Fiscal support has and will have a significant impact on public finances. Measures introduced since summer 2021 already entail a nontrivial budgetary cost (0.5 percent to 1 percent of GDP in France, where the president is facing reelection). New measures in response to elevated energy prices could increase this cost further, perhaps to 1 percent of GDP.
2. Reducing energy reliance on Russia
Continued reliance on energy imports from Russia contradicts the strategy of cutting off the aggressor from international finance and payments. At prices somewhat below current levels ($100/barrel for Brent crude and €100/MWh for gas), oil and gas quantities exported by Russia to the EU in 2019 would be valued at about €200 billion each, in total roughly twice as much as foreign exchange reserves held in G7 countries at end-2021. It is imperative to curtail this income stream.
What would be the point of preventing the Bank of Russia from accessing its reserves if Russia continues to benefit from much-inflated export income? Energy carveouts actually protect the largest part of the Russian banking system from being excluded from SWIFT. All in all, record export income flows are currently entering Russia despite the discount on the price of oil it sells abroad.
Russia is the EU's main supplier of oil (27 percent of imports, 2019 Eurostat data), coal (47 percent), and gas (41 percent). Oil and coal do not require special infrastructure to be delivered to the market. They can be put on a boat and shipped to wherever there is a buyer. Gas, however, is critical because trade depends on infrastructure, meaning that neither the supplier nor the buyer can diversify seamlessly.
A global ban on Russian oil imports is being discussed currently. The question is whether an effective curtailment of Russian sales would result in the price ratcheting up on the global market, which would add to the global supply shock and possibly frustrate the sanctioning effect of the measures taken. A ban can succeed only if cuts in Russian shipments are offset by supplementary exports from other producers.
For gas, Europe and Russia are set to play a game of chicken over their mutual dependency. Russia certainly has leverage. If it were to discontinue exports, the EU would lose about 40 percent of its natural gas supplies. The impact on some EU countries would be catastrophic. This is why Brussels has so far left gas outside the scope of sanctions. But the EU has two assets: Russian gas imports represent only 8.4 percent of its total demand for primary energy, and it has more capacity to diversify its sourcing than Russia has to diversify its export markets. In any case, the EU must prepare to manage without Russian gas, because not planning for such an occurrence would expose it to Russian blackmail.
Shipments from Russia to the EU amounted to 1,800 terawatt hours (TWh) in 2019 (Eurostat data); 2020 and 2021 were abnormal years, out of a total of 3,800 TWh of natural gas imports. But the EU also needs to replenish its reserves, which are running very low. Even if it cuts overall gas consumption by one-fifth and limits the replenishment of reserves to 500 TWh, it will need to import some 3,400 TWh in 2022. If gas stops flowing from Russia (either at EU or Russian initiative), imports from other sources would have to increase by 35 percent.
Replacing Russian gas is feasible but hard (as the International Energy Agency and Bruegel have shown). To start with, it is bound to be costly in the short run, especially if—as for oil—cutting off the leading gas exporter from the global market results in further price escalation. For an EU ban on imports from Russia to be effective, it would need to be designed in a way that takes into account spillbacks onto the global market. Put differently, Europe would need to reduce its demand for imports by increasing the supply from other sources (by delaying the closure of coal and nuclear plants and ramping up the deployment of renewables, for example) and by cutting domestic demand for gas (through dual pricing schemes for domestic heating) and other energies (possibly through limiting speed on highways).
Assuming a halving of Russian gas supply and a 50 percent cost increase for new shipments by non-Russian suppliers (because a higher price would be required to outbid other importers, and because of the extra cost of additional gasification), the extra bill would be €25 billion in 2022 (see calculations in appendix table A.1). Total gas imports would amount to about €370 billion against about €60 billion in 2019 and about €170 billion in 2021.
The next difficulty has to do with intra-EU logistics. The impact of the shock will be very unevenly distributed: Portugal does not import any Russian gas, whereas the share of Russian gas imports in total primary resources is 35 percent for Hungary and 24 percent for Slovakia. The potential for enhancing liquefied natural gas (LNG) terminals is also unequally distributed (Spain has significant capacity, landlocked countries have none), while interconnections are patchy (there is not a European gas pipelines system to speak of). Emergency remedial action will therefore be needed to enhance existing facilities, organize immediate supplies, and launch emergency investments. It is hard to put a number on these initiatives. Assuming they would also increase the cost for the end user by 50 percent, the tag would be another €25 billion in 2022. The map below shows how much of primary energy demand is directly fueled by Russian gas in European countries.
On this basis the short-term cost of reducing energy dependence on Russia could amount to €100 billion: €50 billion to rebuild reserves, assuming 500 TWh priced at €100/MWh (see appendix table A.1), plus €25 billion extra cost of non-Russian supplies, plus €25 billion to organize distribution within the EU. The questions then are: first, how much of it would be borne by private companies and end-users, and how much would have to be borne by public finances; second, how should this cost be shared between individual member states and the EU?
In an emergency situation, when security is at stake and against the background of heightened risk aversion, governments will step in to direct responses to shortages, threats, and risks, and it is prudent to assume that the financing burden will fall disproportionately on public finances. Private companies are neither in charge of security of supply, nor of making sure that all households have access to heating.
Even part of the building up of reserves, normally a purely private task, will need to be publicly financed: Private companies will be reluctant to shoulder the cost of replenishing reserves (€50 billion), because they would risk losing considerable amounts of money if the price of gas normalizes. It is therefore reasonable to assume that taxpayers' money will need to bear three-quarters of the €100 billion cost, or €75 billion.
Part of this burden will need to be shared within the EU despite the fact that while it is true that dependency on Russian gas is a legacy for central and eastern Europe, for Germany or Italy it is the product of a deliberate choice. But to reject solidarity in the name of moral hazard would be far-fetched. After the euro crisis shock and the COVID-19 shock, the fallout from the economic confrontation with Russia is yet another, hardly predictable, asymmetric shock. Cost-sharing is called for, as it was for the COVID-19 crisis. Tight coordination is also called for, unlike what happened in response to the pandemic.
In the medium term, the EU will have to design and finance a wholesale rebuilding of the European energy system that will include the diversification of supply sources, stronger interconnection and the definition of contingency plans for responding to supply disruptions. In so doing, it will need to give significantly more weight to its security objective than in the initial design of the electricity market. Because of a pervasive lack of trust among EU countries, collective energy security was for a long time a topic for speeches rather than for action. The time has come to rethink and build an efficient and secure energy system that makes the best of comparative advantage and treats energy security as a club good. This will require significant investment.
For the immediate future, the upshot is that, whereas the EU cannot realistically dispense with Russian gas altogether, it can immediately prepare for lowering its reliance on it, invest in diversification and commit to a stepwise reduction of its imports (as done in the past with Iran). This policy is bound to entail a significant short-term economic cost, but it is the condition for winning the game of chicken with Russia.
3. Tackling the refugee crisis
The refugee crisis is developing fast. In only ten days, nearly two million people have arrived in Poland and other Central and Eastern European countries. The number will rise further. The long-term cost of welcoming refugees is likely to be negligible, as they may either return to their home country or quickly integrate into the European labor market. But in the short term, they need food, accommodation, healthcare, and education for children.
Estimates of the corresponding cost, for example, by the United Nations High Commissioner for Refugees (UNHCR), are relatively low. Experience shows, however, that costs can quickly mount: in Germany budgetary expenditures on refugees reached €9 billion in 2016, for about 750,000 applicants. If allowances are put at €10 billion per million refugees per year, the cost could easily reach €30 billion in 2022. This cost cannot be borne by the host countries, which are relatively less developed. It will need to be mutualized, mostly through the EU budget and additionally by international agencies such as the UNHCR, as well as charities.
4. Engineering a surge in defense expenditures
The EU has already unlocked immediate support to the Ukraine, with a first €500 million military assistance package (to which bilateral aid should be added). More is likely to be needed in the coming weeks, even if the war ends soon.
Much more importantly from an economic standpoint, Germany has committed to an increase in its defense budget, first through the setting up of a €100 billion debt-financed fund (close to 3 percent of GDP) and more lastingly through a tax-financed increase in defense spending from 1.4 percent to 2 percent of GDP. Other EU countries, with defense budgets close to 1.5 percent of GDP on average, are in similar situations and are likely to follow suit. France is an exception with 2.1 percent of GDP already. But this includes the cost of nuclear forces. France also will need to increase the budget for conventional forces.
Assuming no direct military involvement in the conflict in Ukraine but a gradual ramping up of the defense effort, additional military spending in the EU could easily reach €20 billion in 2022 and twice as much in 2023. The cost will certainly be higher in the medium term. The likely minimum increase in defense spending should be 0.5 percent of GDP or €70 billion, from 2024-2025 onwards. Significantly more is a distinct possibility: in many European countries, the defense budget represented about 3 percent of GDP in the 1980s. It remains to be decided which part of this surge will be financed by taxes, and which by debt.
As things stand, most of this cost will be borne by national budgets, but the EU will also need to step in, at least for the financing of research and development programmes. Potentially stronger involvement of EU public finances will depend on political decisions on whether and how to establish a common European defense policy.
5. A significant transformation and a major budgetary impact
In response to an acute security crisis, the EU and its constituent member states now need to:
- Alleviate the price and income consequences of a new and major supply shock.
- Start reducing imports of Russian gas, while rebuilding inventories for next winter.
- Launch an emergency energy resilience plan to increase non-Russian energy supplies and distribute them within the Union.
- Integrate energy systems much more strongly and build a collective energy security doctrine.
- Mutualize the cost of welcoming refugees from Ukraine.
- Ramp up defense spending and lay the foundations for a common defense policy.
These tasks are only part of a major endeavour that will test the capacity of Europe to act swiftly and decisively, but also to embark on the provision of new public goods it previously had no responsibility for and to organize solidarity. The medium-term implications are also of a first order. So far, the expectation in the EU was that decarbonization, digitalization, and resilience investments would dominate the medium-term agenda. Security—both economic and defense security—is now added to this agenda.
A rough, back-of-the-envelope assessment of the corresponding short-term direct budgetary cost for the EU and its members could sum up to:
- An additional €50 billion to contain the domestic price consequences of an aggravated supply shock through tax cuts and transfers, as discussed in section 1.
- €75 billion on energy independence.
- €30 billion on refugees and humanitarian assistance.
- €20 billion on security and defense in 2022, and twice as much in 2023.
All in all, total discretionary spending and tax cuts could represent €175 billion or about 1¼ percent of EU GDP in 2022. Further expenditures are called for in the medium term, especially on energy security and defense. They could represent at least half a percent of GDP per year.
Part of the burden will fall on the member states (especially for price interventions, targeted transfers, and defense). Together with the adverse macroeconomic shock, these additional costs will disturb the structural consolidation planned for 2023 and beyond. In its March 2 fiscal policy guidance, the European Commission remained cautious. The EU will certainly need to postpone the deactivation of the general escape clause of the Stability and Growth Pact that was initially envisioned for 2023.
At the same time, the adverse shock, heightened risk aversion, and a discount on European assets are likely to aggravate public debt-sustainability concerns in the most fragile member states. The EU's fiscal framework—and national frameworks, such as the German Schuldenbremse—must be made flexible enough to make room for new priorities, but the need for fiscal responsibility is more acute than it has ever been.
The challenge is also significant for the ECB. It will need to avoid tightening prematurely, but also retain flexibility in the allocation of asset purchases, if it wants to prevent a widening of sovereign spreads.
Part of the new programs—especially for the refugees and the redesign of the energy system, and probably in part for defense also—will need to be administered and financed by the EU, for which they will represent a significant addition to its current role and budget. Existing vehicles, including the Next Generation EU package adopted in response to the COVID-19 shock, offer some immediate flexibility to reallocate funds. A new EU budget that should put much more emphasis on European public goods, and a new off-budget package to finance the pressing ramping up of energy security, humanitarian assistance, and joint defense expenditures, may soon be indispensable. The experience with Next Generation EU, the off-budget scheme launched in 2020 in response to the COVID-19 crisis, provides a basis for designing the latter, though it will most probably be less redistributive.
Europe is facing a rethink of its Weltanschauung, its priorities and its policy framework. Jean Monnet famously wrote that "Europe will be forged in crises and will be the sum of the solutions adopted for those crises." We now understand that his prediction should be read literally.
Table A.1 below details the assumptions made in the text on the gas market balances. Data for 2019 serve as bases for hypothetical 2022 projections.
|Table A.1 Technical assumptions for the gas market
|Quantity balances (TWh)
|Final domestic demand
|Total domestic demand
|Gas price (euros/MWh)
|Standard import bill (billions of euros)
|Extra cost of alternative sourcing
|Additional bill (billions of euros)
|Total import bill (billions of euros)
|TWh = terawatt hours; MWh = megawatt hour
|Source: Author's calculations.
Author's Note: I am grateful to all colleagues, especially from Bruegel and PIIE, who provided feedback on an earlier version of this blog. Many thanks to Thomas Belaich for painfully thorough research assistance. The usual disclaimer strongly applies: All errors are mine alone.
2. Calculated using 2019 Eurostat data only, whereas the map uses 2019 Eurostat data for net imports of energy over primary energy demand and Bruegel 2021 data for share of Russian gas imports in total gas imports, yielding 29 percent for Hungary and 28 percent for Slovakia on the map.