The suffering inflicted on the Ukrainian people by the Russian invasion is immense. But, at a much lower level, the war will also inflict costs on people in countries around the world. There will be significant costs to households in the form of even higher energy and food price inflation and a possible economic slowdown. The reactions of governments and central banks could put a further squeeze on living standards. Stock markets could fall further and investment could decline as firms lose confidence.
Russia is the world’s second largest oil supplier and any disruption to supplies will drive up the price of oil significantly. Ahead of the invasion, oil prices were rising. At the beginning of February, Brent crude was around $90 per barrel. With the invasion, it rose above $100 per barrel.
Russia is also a major producer of natural gas. The EU is particularly dependent on Russia, which supplies 40% of its natural gas. With Germany halting approval of the major new gas pipeline under the Baltic from Russia to Germany, Nord Stream 2, the price of gas has rocketed. On the day of the invasion, European gas prices rose by over 50%.
Nevertheless, with the USA deciding not to extend sanctions to Russia’s energy sector, the price of gas fell back by 32% the next day. It remains to be seen just how much the supplies of oil and gas from Russia will be disrupted over the coming weeks.
Both Russia and Ukraine are major suppliers of wheat and maize, between them responsible for 14% of global wheat production and 30% of global wheat exports. A significant rise in the price of wheat and other grains will exacerbate the current rise in food price inflation.
Russia is also a significant supplier of metals, such as copper, platinum, aluminium and nickel, which are used in a wide variety of products. A rise in their price has begun and will further add to inflationary pressures and supply-chain problems which have followed the pandemic.
The effect of these supply shocks can be illustrated in a simple aggregate demand and supply diagram (see Figure 1), which shows a representative economy that imports energy, grain and other resources. Aggregate demand and short-run aggregate supply are initially given by AD0 and SRAS0. Equilibrium is at point a, with real national income (real GDP) of Y0 and a price index of P0.
The supply shock shifts short-run aggregate supply to SRAS1. Equilibrium moves to point b. The price index rises to P1 and real national income falls to Y1. If it is a ‘one-off’ cost increase, then the price index will settle at the new higher level and GDP at the new lower level provided that real aggregate demand remains the same. Inflation will be temporary. If, however, the SRAS curve continues to shift upwards to the left, then cost-push inflation will continue.
These supply-side shocks make the resulting inflation hard for policymakers to deal with. When the problem lies on the demand side, where the inflation is accompanied by an unsustainable boom, a contractionary fiscal and monetary policy can stabilise the economy and reduce inflation. But the inflationary problem today is not demand-pull inflation; it’s cost-push inflation. Disruptions to supply are both driving up prices and causing an economic slowdown – a situation of ‘stagflation’, or even an inflationary recession.
An expansionary policy, such as increasing bond purchases (quantitative easing) or increasing government spending, may help to avoid recession (at least temporarily), but will only exacerbate inflation. In Figure 2, aggregate demand shifts to AD2. Equilibrium moves to point c. Real GDP returns to Y0 (at least temporarily) but the price level rises further, to P2. (Click here for a PowerPoint of the diagram.)
A contractionary policy, such as raising interest rates or taxes, may help to reduce inflation but will make the slowdown worse and could lead to recession. In the diagram, aggregate demand shifts to AD3. Equilibrium moves to point d. The price level returns to P0 (at least temporarily) but real income falls further, to Y3.
In other words, you cannot tackle both the slowdown/recession and the inflation simultaneously by the use of demand-side policy. One requires an expansionary fiscal and/or monetary policy; the other requires fiscal and/or monetary tightening.
Then there are other likely economic stresses. If NATO countries respond by increasing defence expenditure, this will put further strain on public finances.
Sentiment is a key driver of the economy and prices. Expectations tend to be self-fulfilling. So if the war in Ukraine undermines confidence in stock markets and the real economy and further raises inflationary expectations, this pessimistic mood will tend in itself to drive down share prices, drive up inflation and drive down investment and economic growth.
- How will Russia’s invasion of Ukraine hit the global economy?
Financial Times, Chris Giles, Jonathan Wheatley and Valentina Romei (25/2/22)
- Ukraine conflict raises the possibility of stagflation
Financial Times, The Editorial Board (25/2/22)
- Five ways the Ukraine war could push up prices
BBC News, Laura Jones (5/3/22)
- Jason Furman cautions against reading too much into the initial market reactions to Russia’s invasion
interest.co.nz, Jason Furman (26/2/22)
- Putin’s war promises to crush the global economy with inflation and much slower growth
Market Watch, Nouriel Roubini (25/2/22)
- Roubini: 6 Financial, Economic Risks of Russia-Ukraine War
ThinkAdvisor, Janet Levaux (25/2/22)
- Fed tightening plans now contending with war, possible oil shock
Reuters, Howard Schneider and Jonnelle Marte (24/2/22)
- The invasion of Ukraine changed everything for Wall Street
CNN, Julia Horowitz (27/2/22)
- Why the Russian invasion will have huge economic consequences for American families
CNN, Matt Egan (24/2/22)
- European gas prices soar and oil tops $105 after Russia attacks Ukraine
Financial Times, Neil Hume, Emiko Terazono and Tom Wilson (24/2/22)
- Five essential commodities that will be hit by war in Ukraine
The Conversation, Sarah Schiffling and Nikolaos Valantasis Kanellos (24/2/22)
- Ukraine: ‘I’m surprised the oil price hasn’t hit US$130 a barrel yet’ – energy trading expert Q&A
The Conversation, Adi Imsirovic (25/2/22)
- Ukraine crisis: Warning UK energy bills could top £3,000 a year
BBC News, Michael Race (25/2/22)
- Putin’s energy shock: The economic realities of invasion
BBC News, Faisal Islam (25/2/22)
- Fears of UK food and fuel prices rising due to war
BBC News, Oliver Smith & Michael Race (26/2/22)
- Ukraine conflict: What is Swift and why is banning Russia so significant?
BBC News, Russell Hotten (27/2/22)
- Ukraine conflict: How reliant is Europe on Russia for oil and gas?
BBC News, Jake Horton & Daniele Palumbo (25/2/22)
- Ukraine crisis complicates ECB’s path to higher rates
Reuters, Francesco Canepa and Balazs Koranyi (24/2/22)
- Russia and the West are moving towards all out economic war
Al Jazeera, Maximilian Hess (24/2/22)
- If there is a negative supply shock, what will determine the size of the resulting increase in the price level and the rate of inflation over the next one or two years?
- How may expectations affect (a) the size of the increase in the price level; (b) future prices of gas and oil?
- Why did stock markets rise on the day after the invasion of Ukraine?
- Argue the case for and against relaxing monetary policy and delaying tax rises in the light of the economic consequences of the war in Ukraine.
Inflation has been rising around the world as a combination of a recovery in demand and supply-chain issues have resulted in aggregate demand exceeding aggregate supply. Annual consumer price inflation at the beginning of 2022 is around 2.5% in China, 3.5% in Sweden, 5% in the eurozone, Canada and India, 6% in the UK and South Africa, 7% in the USA and 7.5% in Mexico. In each case it is forecast to go a little higher before falling back again.
Inflation in Turkey
In Turkey inflation is much higher. The official annual rate of consumer price inflation in December 2021 was 36.1%, sharply up from 21.3% in November. But according to Turkey’s influential ENAGrup the December rate was much higher still at 82.8%. Official producer price inflation was 79.9% and this will feed through into official consumer price inflation in the coming weeks.
The rise in inflation has hit the poor particularly badly. According to the official statistics, in the year to December 2021, domestic energy prices increased by 34.2%, food by 44.7% and transport by 53.7%. In response, the government has raised the minimum wage by nearly 50% for 2022.
Causes of high and rising inflation
Why is Turkey’s inflation so much higher than in most developed and emerging economies and why has it risen so rapidly? The answer is that aggregate demand has been excessively boosted – well ahead of the ability of supply to respond. This has driven inflation expectations.
Turkey’s leader, President Erdoğan, in recent years has been seeking to stimulate economic growth through a mixture of supply-side, fiscal and monetary policies. He has hoped that the prospect of high growth would encourage both domestic and inward investment and that this would indeed drive the high growth he seeks. To encourage investment he has sought to reduce the reliance on imports through various measures, such as public procurement favouring domestic firms, tax reliefs for business and keeping interest rates down. He has claimed that the policy is focused on investment, production, employment and exports, instead of the ‘vicious circle of high interest rates and low exchange rates’.
With the pandemic, fiscal policy was largely focused on health, social security and employment measures. Such support was aided by a relatively healthy public finances. General government debt was 32% of GDP in 2020. This compares with 74% for the EU and 102% for the G7. Nevertheless, the worsening budget deficit has made future large-scale expenditure on public infrastructure, tax cuts for private business and other supply-side measures more difficult. Support for growth has thus fallen increasingly to monetary policy.
The Turkish central bank is not independent, with the President firing senior officials with whom he disagrees over monetary policy. The same applies to the Finance Ministry, with independently-minded ministers losing their jobs. Monetary and exchange rate policy have thus become the policy of the President. And it is here that a major part of the current problem of rising inflation lies.
Monetary and exchange rate policy
Despite rising inflation, the central bank has reduced interest rates. At its monthly meeting in September 2021, the Turkish central bank reduced its key rate from 19% to 18% and then to 16% in October, to 15% in November and 14% in December. These unprecedented rate cuts saw a large increase in the money supply. M1 rose by 11.7% in November alone; the annual growth rate was 59.5%. Broad money (M2 and M3) similarly rose. M3 grew by an annual rate of 51% in November 2021. The cut in interest rates and rise in money supply led to a rise in nominal expenditure which, in turn, led to higher prices.
The cut in interest rates and rise in nominal aggregate demand led to a large depreciation in the exchange rate. On 1 September 2021, 100 Turkish lira exchanged for $12.05. By 11 January 2022 the rate had fallen to $7.22 – a 40.1% depreciation. This depreciation, in turn, further stoked inflation as the lower exchange rate pushed up the price of imported goods. (Click here for a PowerPoint of the chart.)
Attempts were made to stem this fall in the lira on 20 December, by which point 100 lira were trading for just $5.50 (see chart) and speculation against the lira was gathering momentum. President Erdoğan announced a scheme to protect lira deposits against currency volatility, guaranteeing lira deposits in hard currency terms. The mechanism adopted was a rise in the interest rate on lira deposits with a maturity of 3 to 12 months, thereby encouraging people to lock in deposits for the medium term and not, therefore, to use them to speculate against the lira by buying other currencies. Other interest rates would be unaffected. At the same time the central bank used foreign currency reserves to engage in large-scale purchases of the lira on the foreign exchange market.
The lira rallied. By 23 December, 100 lira were trading for $8.79. But then selling of the lira began again and, as stated above, by early January 100 lira had fallen to $7.22. The underlying problem of excess demand and high inflationary expectations had not been solved.
It remains to be seen whether the President will change his mind and decide that the central bank needs to raise interest rates to reduce inflation and restore confidence.
- Turkish Inflation Hits Highest Since 2002 Amid Lira Woes
Bloomberg, Baris Balci and Cagan Koc (3/1/22)
- Turkey’s annual inflation rate is over 82 percent, finds research group
- How Turkey can overcome its economic challenges
Arab News, Zaid M Belbagi (2/1/22)
- Turkey cuts interest rates despite spiralling inflation
BBC News, Victoria Craig (16/12/21)
- Turkey inflation surges 36% amid lira crisis, highest since 2002
- Turkey mulls new financial instruments to shield against inflation
Daily Sabah (3/1/22)
- Turkey raises minimum wage as lira crash, inflation sow hardship
Aljazeera, Umar Farooq (16/12/21)
- What to make of Turkey’s latest unorthodox currency move
Financial Times, Mohamed El-Erian (21/12/21)
- Erdoğan gambles on economy amid protests and rocketing inflation
The Guardian, Phillip Inman (24/11/21)
- Explained: How did Turkey’s economy go so wrong?
The Indian Express, Patricia Cohen (15/12/21)
- Until the pandemic, the Turkish economy could be seen as a success story. Why?
- What supply-side policies did Turkey pursue?
- Use either an aggregate demand and supply diagram or a dynamic aggregate demand and supply (DAD/DAS) diagram to explain what has happened to inflation in Turkey in the past few months.
- Explain the thinking behind the successive cuts in interest rates since September 2021.
- Why did the measures introduced on 20 December 2021 only temporarily halt the depreciation of the lira?
- Choose a country with a higher rate of inflation than Turkey (see second data link above). Find out the causes of its high rate. Are they similar to those in Turkey?
The LSE’s Centre for Economic Performance has just published a paper looking at the joint impact of Covid-19 and Brexit on the UK economy. Apart from the short-term shocks, both will have a long-term dampening effect on the UK economy. But they will largely affect different sectors.
Covid-19 has affected, and will continue to affect, direct consumer-facing industries, such as shops, the hospitality and leisure industries, public transport and personal services. Brexit will tend to hit those industries most directly involved in trade with Europe, the UK’s biggest trading partner. These industries include manufacturing, financial services, posts and telecommunications, mining and quarrying, and agriculture and fishing.
Despite the fact that largely different sectors will be hit by these two events, the total effect may be greater than from each individually. One of the main reasons for this is the dampening impact of Covid-19 on globalisation. Travel restrictions are likely to remain tighter to more distant countries. And countries are likely to focus on trading within continents or regions rather than the whole world. For the UK, this, other things being equal, would mean an expansion of trade with the EU relative to the rest of the world. But, unless there is a comprehensive free-trade deal with the EU, the UK would not be set to take full advantage of this trend.
Another problem is that the effects of the Covid-19 pandemic have weakened the economy’s ability to cope with further shocks, such as those from Brexit. Depending on the nature (or absence) of a trade deal, Brexit will impose higher burdens on trading companies, including meeting divergent standards and higher administrative costs from greater form filling, inspections and customs delays.
- Referring to the LSE paper, give some examples of industries that are likely to be particularly hard hit by Brexit when the transition period ends? Explain why.
- Why have university finances been particularly badly affected by both Covid-19 and Brexit? Are there any other sectors that have suffered (or will suffer) badly from both events?
- Is there a scenario where globalisation in trade could start to grow again?
- Has Covid-19 affected countries’ comparative advantage in particular products traded with particular countries and, if so, how?
- The authors of the LSE report argue that ‘government policies to stimulate demand, support workers to remain in employment or find new employment, and to support businesses remain essential’. How realistic is it to expect the government to provide additional support to businesses and workers to deal with the shock of Brexit?
Today’s title is inspired from the British Special Air Service (SAS) famous catchphrase, ‘Who Dares Wins’ – similar variations of which have been adopted by several elite army units around the world. The motto is often credited to the founder of the SAS, Sir David Stirling (although similar phrases can be traced back to ancient Rome – including ‘qui audet adipiscitur’, which is Latin for ‘who dares wins’). The motto was used to inspire and remind soldiers that to successfully accomplish difficult missions, one has to take risks (Geraghty, 1980).
In the world of economics and finance, the concept of risk is endemic to investments and to making decisions in an uncertain world. The ‘no free lunch’ principle in finance, for instance, asserts that it is not possible to achieve exceptional returns over the long term without accepting substantial risk (Schachermayer, 2008).
Undoubtedly, one of the riskiest investment instruments you can currently get your hands on is cryptocurrencies. The most well-known of them is Bitcoin (BTC), and its price has varied spectacularly over the past ten years – more than any other asset I have laid my eyes on in my lifetime.
The first published exchange rate of BTC against the US dollar dates back to 5 October 2009 and it shows $1 to be exchangeable for 1309.03 BTC. On 15 December 2017, 1 BTC was traded for $17,900. But then, a year later the exchange rate was down to just over $1 = $3,500. Now, if this is not volatility I don’t know what is!
In such a market, wouldn’t it be wonderful if you could somehow predict changes in market sentiment and volatility trends? In a hot-off-the press article, Shen et al (2019) assert that it may be possible to predict changes in trading volumes and realised volatility of BTC by using the number of BTC-related tweets as a measure of attention. The authors source Twitter data on Bitcoin from BitInfoCharts.com and tick data from Bitstamp, one of the most popular and liquid BTC exchanges, over the period 4/9/2014 to 31/8/2018.
According to the authors:
This measure of investor attention should be more informed than that of Google Trends and therefore may reflect the attention Bitcoin is receiving from more informed investors. We find that the volume of tweets are significant drivers of realised [price] volatility (RV) and trading volume, which is supported by linear and nonlinear Granger causality tests.
They find that, according to Granger causality tests, for the period from 4/9/2014 to 8/10/2017, past days’ tweeting activity influences (or at least forecasts) trading volume. While from 9/10/2017 to 31/8/2018, previous tweets are significant drivers/forecasters of not only trading volume but also realised price volatility.
And before you reach out for your smartphone, let me clarify that, although previous days’ tweets are found in this paper to be good predictors of realised price volatility and trading volume, they have no significant effect on the returns of Bitcoin.
- Explain how the number of tweets can be used to gauge investors’ intentions and how it can be linked to changes in trading volume.
- Using Google Scholar, make a list of articles that have used Twitter and Google Trends to predict returns, volatility and trading volume in financial markets. Present and discuss your findings.
- Would you invest in Bitcoin? Why yes? Why no?
Late January sees the annual global World Economic Forum meeting of politicians, businesspeople and the great and the good at Davos in Switzerland. Global economic, political, social and environmental issues are discussed and, sometimes, agreements are reached between world leaders. The 2019 meeting was somewhat subdued as worries persist about a global slowdown, Brexit and the trade war between the USA and China. Donald Trump, Xi Jinping, Vladimir Putin and Theresa May were all absent, each having more pressing issues to attend to at home.
There was, however, a feeling that the world economic order is changing, with the rise in populism and with less certainty about the continuance of the model of freer trade and a model of capitalism modified by market intervention. There was also concern about the roles of the three major international institutions set up at the end of World War II: the IMF, the World Bank and the WTO (formerly the GATT). In a key speech, Angela Merkel urged countries not to abandon the world economic order that such institutions help to maintain. The world can only resolve disputes and promote development, she argued, by co-operating and respecting the role of such institutions.
But the role of these institutions has been a topic of controversy for many years and their role has changed somewhat. Originally, the IMF’s role was to support an adjustable peg exchange rate system (the ‘Bretton Woods‘ system) with the US dollar as the international reserve currency. It would lend to countries in balance of payments deficit to allow them to maintain their rate pegged to the dollar unless it was perceived to be a fundamental deficit, in which case they were expected to devalue their currency. The system collapsed in 1971, but the IMF continued to provide short-term, and sometimes longer-term, finance to countries in balance of payments difficulties.
The World Bank was primarily set up to provide development finance to poorer countries. The General Agreement on Tariffs and Trade (GATT) and then the WTO were set up to encourage freer trade and to resolve trade disputes.
However, the institutions were perceived with suspicion by many developing countries and by more left-leaning developed countries, who saw them as part of the ‘Washington consensus’. Loans from the IMF and World Bank were normally contingent on countries pursuing policies of market liberalisation, financial deregulation and privatisation.
Although there has been some movement, especially by the IMF, towards acknowledging market failures and supporting a more broadly-based development, there are still many economists and commentators calling for more radical reform of these institutions. They advocate that the World Bank and IMF should directly support investment – public as well as private – and support the Green New Deal.
- What was the Bretton Woods system that was adopted at the end of World War II?
- What did Keynes propose as an alternative to the system that was actually adopted?
- Explain the roles of (a) the IMF, (b) the World Bank, (c) the WTO (formerly the GATT).
- What is meant by an adjustable exchange rate system?
- Why did the Bretton Woods system collapse in 1971?
- How have the roles of the IMF, World Bank and WTO/GATT evolved since they were founded?
- What reforms would you suggest to each of the three institutions and why?
- What threats are there currently to the international economic order?
- Summarise the arguments about the world economic order made by Angela Merkel in her address to the World Economic Forum.