John FitzGerald: Ukraine shock waves to be felt for some time

Role of government not to try stop inevitable, but to protect vulnerable against high prices

Faced with the ongoing calamity in Ukraine, it is difficult to assess the economic fallout. The exceptional rise in energy prices is already affecting us, along with the rest of Europe. Price effects will continue to ripple through our economy because Russia and Ukraine are important suppliers of commodities like wheat to the rest of the world.

Income is being transferred from energy consumers to energy producers, leaving individual consumers with less cash to spend on other items. This won’t be counterbalanced by extra spending from oil and gas-rich countries – these are generally slow to spend windfall gains.

Heightened risk will also have an adverse effect on investment, so overall world demand is likely to be hit.

The challenge of supporting millions of refugees will require major government funding. Along with fellow EU members, Ireland will have to spend up to 1 per cent of national income over the coming year to harbour and protect a very large number of displaced people.

A major cost will be the provision of “temporary” accommodation, which could turn out to be more permanent than one would like.

The combined effects of the rise in prices and the lower world demand will hit all economies, including Ireland’s.

An initial study by the UK National Institute for Economic and Social Research suggests that war in the Ukraine will cut euro-area GDP by 1.5 percentage points by the end of next year.

However, this cut in GDP will be more than offset by what was shaping up to be a very vigorous recovery this year. Because the goods and services we sell to the rest of the world will be largely unaffected by the wider global challenges, the Irish economy will continue to grow in 2022, though more slowly than we would like. Some of this growth will go to pay our higher energy bills.

Inflation

During 2020, as a result of the pandemic-induced recession, there was a very substantial fall in energy prices, bringing down overall inflation. The recovery in 2021 inevitably saw prices rebound.

Up to December of last year consumer prices were 4.2 per cent above where they had been at the end of 2019 – taken over the two years an average rate of inflation of 2 per cent a year. Although inflation has similarly averaged around 2 per cent over the preceding 20 years, the 2020 price fall was forgotten and consumers were unhappy at the sharp rebound.

In addition, the impact of the war in Ukraine on prices, especially energy prices, has given a further major inflationary shock. While reminiscent of the oil price shock of the 1970s, the actual economic impact of the energy price surge is likely to be much less this time round given how much more energy-efficient our economy is today.

In 1974 higher oil prices cost Ireland 4 per cent of national income – a massive loss with huge consequences for the standard of living. This time round the additional cost of our energy in 2022 will probably reduce our standard of living by up to 2 per cent of national income (or over 2.5 per cent compared to the exceptional pandemic year of 2020).

While it is of no consolation to two million households who will have to pay so much of their income to the world’s energy producers to keep their lights on, the ultimate economic consequences are likely to be much milder than in the 1970s.

Ireland’s aircraft leasing companies are likely to lose a huge sum on the aircraft that they cannot repossess in Russia. However, Irish lenders are not exposed to this shock so this loss will be passed on to the foreign financiers of these investments or to their insurers.

Lessons

One of the lessons of the more severe oil crisis in the 1970s is that there is no way of disguising the hit to our incomes from a major energy price shock – we are all worse off.

The role of government is not, like King Canute, to try to stop the inevitable but rather to protect those who are most vulnerable to the higher prices.

A further complication could be disruption to Europe’s gas supply, particularly if the EU wants to wean itself off dependence on Russian gas by the end of the year. It would require a further rise in gas prices to attract liquefied gas to Europe from the Asian market, with a knock-on impact on the cost of energy for Asia.

That in turn would depress incomes and production across Asia, and extend the economic shock to that region. Worldwide those who are poorest will be most vulnerable in any recession.