The shooting down of Malaysia Airlines Flight MH17 is a catastrophe of a different category. This horrific crime has the potential of turning an important regional conflict into a first-order global shock. Policy makers should prepare for this.
The much-ridiculed western sanctions against Russia have already had a much bigger effect than the headline numbers suggested. Foreign investors suddenly saw risk where before they saw none. Regulatory permissions were withheld — as in the case of Gazprom’s recent application to use spare capacity of a German gas pipeline. Uncertainty affects market valuations. The indirect effects trump the direct ones.
President Vladimir Putin’s annexation of Crimea and the global response to it have left Russia on the brink of recession. We do not know for certain to what extent they contributed to the lacklustre economic recovery in the Eurozone. The German economy in particular weakened just as the conflict escalated. This is probably no coincidence.
Earlier last week, the US administration imposed the most serious package of sanctions against Moscow to date. Two Russian banks, Rosneft, a gas producer, another oil company and several defence equipment contractors, were all cut off from important sections of US capital markets. In a global dollar-based system, financial sanctions are potent. US law does not apply directly in third countries, but any company or country that funds itself in dollars is often indirectly subject to American law because part of the transaction chain goes through US financial infrastructure. This is how US courts exercised leverage over Argentina in a legal dispute about the country’s sovereign default. The dollar monopoly makes financial sanctions self-enforcing.
The European Union (EU) is not there yet. On the day the US applied its latest sanctions, the European Council decided to cut lending to Russia from the European Investment Bank — a largely symbolic gesture. It was also trying to get the European Bank for Reconstruction and Development to stop lending to Moscow, which would be more significant. By its own standards, the EU has already done quite a lot. And even before last Thursday, it was ready to do more.
EU member states have different interests. Germany and Italy, for example, have strong relations and trade links with Russia. Nobody wants to contribute to a further escalation of the crisis, but I expect the sense of solidarity with the Netherlands to be very strong. Apart from the large number of Dutch, Malaysian, Australian and Indonesians victims, there were also casualties from the United Kingdom, Germany and Belgium. That may further unify the European position.
If it is confirmed that MH17 was shot down — even if by accident — by pro-Russian separatists, the EU will need to harden its response. It should go for all-out financial sanctions. The euro and pound are important global funding currencies for Russian companies. The City of London is a financial market through which wealthy Russians launder their money. That should be stopped immediately.
In addition to a financial embargo, the EU should also consider a ban on energy imports — clearly, the most vulnerable industrial sector. The EU should implement an energy security strategy as an emergency measure to make it independent from Russian supplies.
If Putin has covertly armed Ukrainian rebels who ended up assassinating EU citizens, it would be hard to return to business as usual for a very long time.
There are, of course, alternative explanations of what might have happened on Thursday. None are comforting. Whatever conspiracy theory one might wish to believe, it is hard to construe one that is simultaneously plausible and politically and economically benign.
The precise global economic impact of all of this is hard to predict, but from what we have seen so far, we should not exclude that we are dealing with a first-order global economic shock. The macroeconomic impact will continue to exceed the notional sums by a wide margin — because of knock-on consequences due to network effects and the impact on confidence and valuations and just general uncertainty.
The Eurozone can expect to be directly affected. Commentators note that the Eurozone is only one shock away from deflation. This may be that shock. And if it were to delay recovery by only another year — hardly the worst-case scenario — inflation forecasts may keep falling.
Europe has learnt the lessons of 1914. It is not sleepwalking into another large continental war. However, Europe has not learnt the lesson of 1998 when the onset of the Asian crisis turned a Japanese balance sheet recession into a perma-depression.
European policymakers should never have put themselves in a position where they cannot respond politically for economic reasons.
— Financial Times
