Europe’s economy resilient to war fallout – for now

13 March 2023

Economically, the EU has coped with the Ukraine war much better than expected. But if it cannot translate its economic power into political influence, it will remain vulnerable to external shocks

image credit: Lue

This text is an extended translation of the op-ed first published on the website of the Austrian daily “Die Presse” on 7 March 2023.

Collapsing industries, mass unemployment, record inflation. After Russia’s brutal invasion of Ukraine, there was great fear that the EU would slide into a catastrophic recession. The 27 EU members entered into an economic war with Russia at a time when they were still suffering from the consequences of the Covid-19 pandemic.

Indeed, the initial economic shock was substantial, particularly from skyrocketing inflation. Although this was already high before the war, Russian President Vladimir Putin’s decision to stop most gas supplies to Europe in response to the sanctions escalated the situation and led to a massive further increase in energy prices.

Nevertheless, the feared economic slump failed to materialise. According to the latest forecasts of the EU Commission, the EU will be able to avoid a recession this year. In addition, the Commission assumes that inflation has already peaked. Unemployment is low and there are no signs of an acute gas shortage.

How did the EU manage this? There are several reasons for the EU’s relative resilience. First, the rise in gas prices did not last long: since peaking in August 2022, they have already tumbled by 85% (even if it takes some time for this to filter through to consumers). Gas supplies from other providers, such as the US and Norway, have helped. Oil prices have also fallen considerably. Thus, Putin’s strategy of using energy as a weapon has failed miserably.

Second, EU economies have demonstrated an impressive level of resilience. It is true that the warm winter helped, as did weak demand from China. Nevertheless, the economic adjustment process has been decisive, especially in industry. According to the Brussels-based think tank Bruegel, gas consumption in industry across the EU fell by an average of 15% in 2022, compared to the average for the last three years; and yet industrial production in the EU in December 2022 was slightly above pre-war levels.

Third, governments have taken numerous measures to contain the impact of the energy price shock. Their logic and effectiveness are in part questionable; they have kept gas demand artificially high; and they are unlikely to be financially sustainable in the long term. Nevertheless, they did save the EU population from the worst effects in the short term.

Finally, the invasion took place at a time when the Europeans had already largely decoupled from Russia, except for energy and raw materials. Economic decoupling began as far back as 2014, after the annexation of Crimea, when the EU imposed its first sanctions on Russia.

Major challenges ahead

Although the EU has so far come through the crisis better than expected, there is little room for complacency. Difficult months lie ahead. The war and its aftermath, combined with an intensifying rivalry between China and the US, will pose enormous economic problems for the Europeans.

The first key challenge is that Europe will have to get used to permanently higher energy prices. Despite a massive decline since last summer, the price of natural gas is still more than double its long-term level. Also, Russia’s enormous reserves will remain out of the market for many years: Russia is unwilling to sell its gas to much of Europe; and until pipelines to China are built, it cannot sell the gas there. The recovery of the Chinese economy after the end of ‘zero Covid’ is also likely to push energy prices up again. Permanently more expensive energy endangers the competitiveness of European industry and carries with it the risk that some firms could relocate production to places where energy prices are lower, including the US.

A second major challenge is that the EU economy, which, by global standards, is open and trade dependent, has much to lose at a time of escalating geo-economic competition between China and the US, especially as the EU is moving ever more firmly towards alignment with the US. Although reports of the demise of globalisation have been greatly exaggerated, it is hard to imagine that supply chains will be unaffected by these tensions over the coming years. Economic bloc-building may serve geo-political ends and improve the resilience of supply chains; but it is also likely to increase costs, further exacerbating the inflation challenge for the EU.

Ukraine’s accession to the EU as a turning point

Perhaps the biggest challenge facing the EU in the coming years, however, is the impact of the war on the European integration process. Ukrainians are fighting heroically against the Russian invasion and deserve all possible support from the EU to build a strong economy and to integrate further with the EU after the war (it is to be hoped that military support will also arrive more quickly and in greater volumes this year). The EU is set to take the leading role in Ukraine’s post-war reconstruction – as it should – and Ukraine’s status as a candidate country fundamentally changes the accession process, not only because of the huge reconstruction costs, but also because of the country’s size, its level of development and the scale of its agriculture sector. Given these circumstances, it is impossible to imagine EU enlargement, which has almost ground to a halt over the past 15 years, continuing as before.

This also has huge implications for the Western Balkans. Though some countries of that region have theoretically been engaged in the enlargement process for two decades now, there is great frustration at the glacial base of accession and the vetoes of existing member states. In parts of the Western Balkans, the influence of China and Russia is also strong: that could further complicate the accession process and challenge EU interests. Here, the war in Ukraine must serve as a wake-up call to speed along the region’s EU integration. Even if no country in the Western Balkans joins the EU in the foreseeable future, the bloc must do much more to deepen the region’s economic integration and accelerate its economic development – and thereby safeguard the EU’s own interests in the region.

This is also argued in a new study that we presented, together with the Bertelsmann Stiftung, at the Munich Security Conference 2023: the EU should make greater use of its economic influence in its own neighbourhood, in order to influence developments there in its favour. This also means that the Western Balkans and the states in the European neighbourhood, such as Ukraine, Moldova and Georgia, must be integrated more strongly economically. This requires better access to the EU market for them, increased aid from the EU budget and greater infrastructure investment. The EU should also do all it can to help these countries take advantage of trends towards nearshoring, i.e. attracting manufacturing industries from the EU’s core countries.

However, increased EU engagement must be conditional on strict requirements for political and economic reforms as the countries move towards eventual EU accession.

The war in Ukraine has changed Europe fundamentally and will create a geo-political and geo-economic divide that is harder than anything seen on the continent in the last 30 years. In partnership with the US, the EU must recognise this change, and cast off the naivety that has characterised some of its dealings with its neighbours in the recent past. The EU has much more to offer the citizens of its neighbourhood than either Russia or China, but only if it recognises – and is willing to use – the levers at its disposal, in partnership with the US. If the EU still fails to act strategically and deepen integration with neighbouring countries in order to influence political and economic developments there in its own interests, it will remain vulnerable to future shocks from its neighbourhood.