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The Ukraine war could be the last straw for Western economies

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THESE days I seem to write a lot of negative stuff. Believe me, it gives me no pleasure to do so. 

There is so much good in the world. We have inherited so much good fortune from the creativity, traditions and culture of the West generally, and this country in particular. We are blessed with wonderful small things: the daffodils are out, birds are singing and nesting again, while the splendid Radio 3 presenters demonstrate the glories of the western tradition as it fades elsewhere.

I contrast that with the terrible mess those who profess to govern us are making of our civilisation. It would be a travesty to compare the greatness of the symphony or the simplicity of a tweeting bird with the clanging cymbals of our politicians, but we are witnessing our great traditions being undone.

I have always viewed economics as a simple means to an end, not an end in itself. Economically strong nations and people are usually secure, culturally creative and scientifically enabled. Economics may have been described as ‘the dismal science’ but it is, or attempts to be, the cornerstone of all that can be build. 

Unfortunately, we have moved so far from the classical liberal view of minimal interference and a small state, which did so much to build our 19th century economic pre-eminence, strong institutions and general prosperity, to the current astonishing situation where, despite all the evidence to the contrary, our politicians really believe they are ‘doing good’ and commanding the economic heights delivering us from disaster. 

For a generation or more, politicians both Conservative and Labour, aided and abetted by the Treasury, have taken it upon themselves to control more and more of the economy. The modern phase of this process started with the Major Government and greatly gathered steam under Blair and Brown.

Perhaps the Rubicon moment was the global financial crisis around 2008-9. The policy response was largely developed by Gordon Brown’s team and adopted globally. The plan was to slash interest rates to near zero and use quantitative easing (QE) to reflate the busted economy, so scared were they by the lesson of America in the 1930s depression. 

Given the imperative of averting depression, there was certainly a credible case to adopt such a radical measure. The impact of this monetary policy is, however, not widely understood and nor are the side effects. It did not just reflate asset prices, creating winners and losers, but also enabled Government to borrow unprecedented sums with ease. It massively expanded Government regulation across a wide range of industries, in banking and financial services in particular. 

At the time I wrote a paper titled A bubble on a bubble arguing that if the popping of a credit bubble had caused the global financial crisis, current monetary policy risked creating an even bigger bubble with devastating consequences. It made me very bullish on capital markets, but not so on underlying economic health, a cleft that would only widen. 

I do believe while there was some justification for the monetary policy adopted it had to be used sparingly with a return to ‘monetary normalisation’ as soon as possible. Unfortunately, there was to be no return to monetary normalisation for on the eve of lockdown, some 12 years later, interest rates were still near zero and all the QE remained on the books. 

In my view, central bankers and politicians enjoyed the free ‘sugar rush’ for far too long, unwilling to take tougher decisions which would ultimately have provided a stronger long-term foundation. The situation in the eurozone was and is even more out of step.

However, after the global financial crisis there were no devastating consequences. By 2016 the Bank of England had ‘printed’ £445billion of QE and there was very little inflation, leading some to conclude that central banks could manage the cycle simply by printing, or potentially withdrawing money, at will – thus not being constrained by such old-fashioned ideas as that wealth is created by productivity, innovation and, in the broad sense of the word, industry. Indeed, taking it to its logical conclusion, why work at all and not simply issue credit notes so we can all lie back on a chaise longue being fed grapes?

Inflation appeared not to be impacted by QE and near zero interest rates, but in my view this was really down to three factors: 1) China; 2) a massive technology-driven productivity benefit; 3) global migration flows subduing labour rates. Even that broad summary would be misleading as the inflation rate (CPI) is an average number. Trips to Aldi and Primark may well be cheap, but rarefied product such as luxury hotels, fine wine, school fees and asset prices, which are not picked up by CPI, certainly accelerated.

After a decade of lacklustre growth and higher tax, but asset inflation, the public finances had just about stabilised. Then came lockdowns. To my mind the global and UK response was foolish in the extreme with untold moral, medical, social and economic harms. This is not the place to discuss that, but the economic impact more than doubled the level of QE (money printing) again to £895billion – some 40 per cent of the entire GDP and maintain rates at near zero.

Explained simplistically, the entire lockdown was funded by QE. The central bank wouldn’t view it that way, but the stock of privately held gilts did not rise despite an excess £500billion of issuance over lockdown. This QE, unlike the first round, seems to have gone far more directly into the economy via such productive schemes as furlough, Test and Trace, bounce-back loans and yet more public spending.

So lockdown caused an extension of, let’s call it, the monetary experiment, with a massive increase in the public sector all when supply chain issues occurred due to closures and the dash to delusion of woke economics most costly in the sense of net zero.

Inflation was picking up strongly well before the Ukraine war, both in the UK and globally. This time, in my view, it was going to be hard to put a lid on it as the classic measure of raising interest rates was not readily available, outside the margin, so weaned was our and other western economies on cheap money. Raise rates too far and a recession would be inevitable. Don’t raise them and how is inflation quelled? If we have learned anything from the last decade, politicians generally prioritise short-term growth over long-term stability. Jam today, please!

That was bad and potentially materially so. What followed was tragic. The crisis in the Ukraine had been building from at least 2014, probably earlier. Again, this is not the place to discuss its genesis, but the impact of this terrible war is the last straw for Western economies. 

While the West and Russia do not trade in many finished goods or services, Russia is a key commodity exporter and in many cases the swing exporter. The loss of its supply has thus had a disproportionate impact on price, hence the oil price surging from around $60-80 a barrel before this crisis to $122 at the time of writing. 

Russia produces 11.2million barrels of oil each year and with the US and Saudi Arabia is one of the three paramount producers. To put that in context, Russian production is 11 times North Sea production. Further it accounts for 38 per cent of European gas supply. Russia provides 22 per cent of wheat exports to Africa, 24 per cent of fertiliser to America and is a key exporter of nickel, palladium, and platinum, steel and aluminium and sunflower oil, to name a few other key commodities. 

These are all supply issues where alternatives are not quickly readily available, with a potentially significant and long-lasting impact on pricing and ultimately inflation. Russian exports are thus largely base products that are inputs into a wide range of everyday items. In this light, inflation is now heading in my view to at least 10 per cent and quite possibly a good deal higher. Unlike the Office of Budget Responsibility forecast, I expect it to remain embedded for some time. I am also struggling to see how a recession can be avoided. I hope I am wrong.

In this same light, Wednesday’s Spring Statement is wholly inadequate. In fairness to the Chancellor, the genesis of our precarious economic position well predates him, but it raises the question ‘what next?’ 

There are many unknowns. We do not know how long conflict will last but it seems to me this is likely to be protracted with little sign of attempts to de-escalate from Washington, London, Brussels or Moscow. It also seems improbable, regardless of outcome, that Russia will avoid Western sanctions for a considerable time, potentially many years. 

We had therefore better get used to high energy prices, and as a reference the current spot is around 50 per cent higher than the 40 per cent-odd consumer energy bill price rises already announced for April. We are in the uncomfortable position where interest rates are 0.75 per cent and inflation is heading to 10 per cent. Not good for savers. 

What happens to the public finances if we head for recession? The deficit will of course greatly increase and I suspect the Chancellor will attempt a further fiscal stimulus. Last time the Bank of England effectively funded the deficit via QE. There was some credibility to QE when inflation was low, but would the central bank really use QE to fund the deficit if inflation is high? If not, who would buy the excess gilts? Certainly not me, with a yield of 1.69 per cent for the ten-year benchmark when inflation is heading to 10 per cent. 

No, I’ll wager, God forbid, that if we do head to recession HMG will try to stimulate the economy again. I fear the Bank of England will be tempted to use QE again as the lesser evil compared with a rising yield curve which would kill the economy. In my view, however, to employ QE when inflation is high would be dangerous in the extreme. And if it’s bad for the Bank of England it’s probably worse for the ECB with the eurozone’s greater dependency on Russian energy, a continuing banking crisis and economic dislocation between north and south. This is a house of cards, and a precarious one.

We are where we are from a decade and more of highly experimental monetary policy. There is little good crying over spilt milk. There are few easy solutions but the best one, albeit only achievable to the longer term, is to reverse the tide of state interference. 

The private sector has been battered by lockdown and will be battered by the energy shock. We need to cut public spending, in some areas radically, to enable the private sector to flourish. There are numerous regulations that could be simplified and cut. Britain continues to have significant strategic advantage in financial, technology, medical, logistics and cultural sectors in particular. If we are to succeed, politicians need to stop this endless interference and cut tax, now at a 70-year high. 

What Putin does is largely beyond our control. But much is within our control. It’s time to end this constant virtue-signalling and concentrate on what works, frankly the only thing that can pay for public services in the long term, by trusting the private sector and the family unit to flourish – and flourish they will without constant inference. The public sector is not fit for purpose but the private sector broadly is: build what works, scale back what does not.

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Ewen Stewart
Ewen Stewart
Ewen Stewart is a City economist who runs the consultancy Walbrook Economics. He is director of the think tank Global Britain and his work is widely published in economics and political journals.

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