War made the State

Key Points

• The consequences of the war in Ukraine will be unequal across social groups in Europe. Redistributive pressure will add to the fiscal drift triggered by the acceleration in the energy transition and the rise in military spending.
• The ECB is probably ready to slow down its policy normalization, but the direction of travel remains clear. It would be wrong to count on debt monetization to make this fiscal drift painless.

Major political economy shifts often coincide with wars or preparation of wars. They do not simply affect how resources are affected to defend against external threats. They also shape priorities on civil spending to maximize internal social cohesion. Building a comprehensive welfare state as a demonstration of the West’s superiority against the Communist bloc was part and parcel of the cold war. Fighting Covid was a “near war experience” which has accelerated a pendulum shift towards interventionism again. In western societies, the awareness of deep divisions before the pandemic, reflected in the rise of populism, probably played a role. Without massive support to household income and job security, they may not have been able to withstand the degree of collective and individual constraints made necessary by the sanitary situation.

European economies and societies are going to be tested again by the Ukraine war. While polls suggest public opinion is ready to accept some economic sacrifice because of the sanctions against Russia, additional fiscal support is unavoidable. The distribution of the shock across social groups is likely to be highly unequal.  The surge in inflation will be the most intense for energy and food, two items which stand for a high share of the consumption basket at the bottom of the income ladder. This “redistributive pressure” will add to the acceleration in the energy transition and the rise in military spending in a new fiscal drift.

A major difference with the pandemic is that the ECB is not in the same situation to help governments fund a new rise in public debt. This time, inflation is the first manifestation of the crisis in the economic realm, not a lagged effect. While this week we expect Christine Lagarde to communicate a slower pace of policy normalization than could have been expected after the February meeting, we think the general direction of travel has not changed.  In uncertain times central bankers tend to react with two historical precedents in mind. One is the policy mistake of maintaining a too hawkish stance during the Great Depression of the 1930s. The other is the symmetric policy mistake of maintaining a too dovish stance during the 1970s.  They have spent the last 14 years reading Bernanke’s “Essays on the great depression”. They might be dusting their Milton Friedman now. The fiscal drift is not going to be painless.