Ukraine’s long shadow over the European economic recovery

The escalation of the trade war between the West and Russia over the Ukrainian crisis casts a long shadow over the European economic recovery. It underlines how irreconcilable are the differences between Russia and the West as to Russia’s legitimate geopolitical interests. A protracted standoff between Russia and the West over Ukraine is almost certain to increase the amount of financing that the West will need to provide Ukraine to keep that country afloat. More serious yet, it is bound to continue to undermine European investor and consumer confidence at a time of great fragility in the European economic recovery.

{mosads}At the core of the escalation of Western sanctions and of Russian counter-sanctions is a fundamental difference of view as to Russia’s legitimate interest in Ukraine. For deep-seated historical reasons, including several external invasions through Ukraine, Russia believes that it has a legitimate geopolitical interest in a nonaligned Ukraine that remains outside NATO and outside the European Union. For its part, the West believes that in the new world order, Ukraine should have the right to choose with whom it wishes to associate and to which organizations it wishes to belong. Further complicating matters is the fact that Russian President Vladimir Putin’s standing up to the West plays well politically at home.

The recent moves by the West and the Russian countermoves would lend support to the view that the basic differences between the two parties will not be reconciled anytime soon. Highly skeptical of Russia’s intentions regarding the recently agreed cease-fire, the West has now broadened its sanctions to include a wider range of individuals and corporations as well as to further target the Russian oil and defense sectors. For its part, the Russians are now threatening to broaden their counter-sanctions to include clothing and used cars as well as to restrict its airspace to Western aviation. More ominously still, the Russians are now restricting natural gas exports to countries like Poland and Slovakia to make sure that Ukraine cannot offset a Russian natural gas embargo with gas imports from third countries.

To its credit, the International Monetary Fund (IMF) is now acknowledging that the cost of keeping Ukraine afloat could be very much higher than was initially estimated in its April lending program. The IMF now thinks that in the event of a continuation of hostilities in eastern Ukraine, an additional $19 billion might be needed to keep Ukraine afloat through 2015. Presumably a big part of this bill will need to be picked up by the Europeans. There is also every likelihood that even more financing would be required were Russia to keep its natural gas spigot to Ukraine turned off this winter, which would almost certainly accentuate the very deep economic recession that Ukraine is already experiencing.

A prolonged standoff between Russia and the West would be highly detrimental to the Russian economy, which is already on the cusp of an economic recession. This would certainly not be good for European exports to Russia. However, the main impact that a continued standoff with Russia would have on the European economy would be the result of a further blow to European investor confidence as well as to the possibility that Russia would play its energy card this winter. As the provider of around 30 percent of European energy needs, a Russian decision to restrict natural exports to Europe could be a major blow for the European economy.

Already in the second quarter of 2014, in large measure due to the Ukrainian crisis, the European economic recovery ground to a halt while Europe moved ever closer to outright price deflation. With every prospect that the Ukrainian crisis will drag on through the winter, one would think that there is a reasonable chance that Europe will lapse into a triple-dip economic recession and that inflation will continue its downward path toward outright deflation. For that reason alone, one has to regret that the European Central Bank (ECB) remains reluctant to embrace a full-bodied policy of quantitative easing now to jump-start the European economy. By the time that the ECB is forced to do so, it might be too late to avoid a debilitating debt-deflation trap in the European economic periphery.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

Tags ECB European Central Bank IMF International Monetary Fund Russia sanctions Ukraine Vladimir Putin

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