Peace talks have started. We do not know how soon or exactly where they will land. But things are moving fast. While much of the focus is, rightly, on the unexpectedly daunting geostrategic challenges, it’s not too soon to start mapping out the key economic implications for Europe.
PUBLIC DEBT AND DEFENSE SPENDING AS A SHARE OF GDP
Overall, the implications should be positive both in the near and the longer term; how much will depend to a large extent on decisions Europe itself makes. In a nutshell, the ceasefire should boost GDP growth in the near term primarily through the demand channel, with scope for a long-term boost to potential output. The impact on inflation is more uncertain, as there are multiple drivers going in opposite directions, but overall more limited, and European currencies might benefit as well (dampening inflation). These impacts would be most pronounced on Central and Eastern European countries, and least pronounced on the UK, with Western Europe in between.
The central scenario assumed here is one where the ceasefire agreement freezes the conflict broadly along the current frontline (with 19% of Ukraine territory occupied). Actual peace, with internationally-recognized borders and full re-integration of Russia in the global economy still seems elusive for the foreseeable future. A majority of the 5-8 million Ukrainian refugees living in Europe gradually return home. Reconstruction begins immediately. Both EU and UK take immediate steps to boost defense spending very meaningfully to make up for the US curtailing its own involvement.
By far the biggest economic driver will be increased defense spending. Until a few days ago, estimates of the economic dividends of peace emphasized the confidence boost for Europe that it would entail. But this will now be offset by the previously unimagined prospect of a fundamental geostrategic pivot from the US away from Europe. Estimates of what’s needed to make up for this pullout range around USD 250-300bn per year, bringing total defense spending to 3.5% of GDP (from 2% currently).[1] Estimates suggest an elasticity of 0.5 to 1 for defense spending in the EU, i.e. an increase in spending of 1.5% of GDP should boost GDP by around 0.9 to 1.5% (even accounting for substantial “leakage” through imports of equipment, which should diminish over time based on EU leaders statements of intent). Above and beyond this cyclical boost, there is a potential positive impact on productivity, to the extent that a meaningful part of the defense spending is allocated to R&D that subsequently benefits the entire economy.
Most of this increase in defense spending should not, initially, need to be offset by cuts in other spending. As seen in the chart, many EU members in need to boost defense spending have the fiscal space to do so. Others, like France or Italy, are much more constrained, but the EU is considering activating the escape clause to suspend its fiscal rules to provide additional flexibility, and discussions are reportedly progressing fast on EU-level financing, whether by repurposing existing funds or even new common borrowing. The UK, by contrast, appears much more constrained and may therefore not benefit from direct extra fiscal stimulus. It should, however, receive positive spillovers from the additional growth and defense spending of its European neighbours. Over the longer term, however, sustaining much higher defense spending could only be accommodated through higher revenue collection, or cuts in other types of expenditures. Any permanent boost to growth would then be down to productivity effects.
An additional boost to growth might be expected via higher exports to Ukraine as rebuilding gets underway. Reconstruction needs were estimated in early 2024 by International Organizations at nearly $500bn over the coming decade.[2] They are likely larger now. Raising financing of that scale will be an issue, particularly if international consensus on the use of frozen Russian assets to this end remains lacking. But the EU has already pledged a 50bn euros facility which will enable to kick-start rebuilding of essential infrastructure such as housing, transportation and productive capacity. In the longer term, both the EU and Ukraine have much to gain from greater economic integration, with Ukraine being rich in natural resources that Europe has identified as critical to its economic sovereignty, as well as a potential AI and tech powerhouse.[3]
Conversely, the return of refugees to Ukraine will negatively impact European growth, but this impact should be small and gradual overall. The largest contingents of refugees settled in Germany, Poland, and to a lesser extent the Czech Republic, with relatively large numbers (approx. 200,000) in Spain and UK as well. It is hard to estimate what percentage of these refugees will eventually return home. In the UK, where a large proportion are employed, surveys suggest a large majority would prefer to stay. Poland and the Czech Republic appear more vulnerable for having both large numbers of refugees and a high share of them employed. Their return home would reduce both labor supply and demand. In Germany, where a much lower share of the Ukrainian refugees are employed, the impact would be felt primarily via lower demand, though on the scale of the German economy this impact would be negligible.
Decisions regarding usage of Russian gas via the Ukraine pipeline will have a significant impact on both growth and inflation. From a technical standpoint, this is the only operational one. Reopening it would require Ukraine’s agreement (for which transit fees will be an incentive) as well as interest from neighboring EU members to purchase this gas.[4] This prospect has already contributed to pull down the reference spot price (TTF) by 10%, and further downward movement would be highly likely, perhaps by as much as 20-25% overall, everything else equal. This would benefit all European importers of gas in the form of higher growth and lower inflation.
By contrast, the ceasefire should have a negligible impact on other commodities. Ukraine’s production of cereals and other food products is running roughly at its pre-invasion level apart from the portion that used to come from the currently occupied territories. Russian oil exports have remained constrained more by OPEC+ quotas than by sanctions, and its exports of other commodities have not been sanctioned.
Transportation costs might decrease, however, in the event of return to pre-war traffic of the Black Sea transit route (recent tonnage has been running at about 50% of the pre-war level).
In sum, while deep uncertainties remain, a ceasefire broadly along the lines of our central scenario, coupled with sensible economic policy decisions, can be seen as another upside risk to the European outlook, consisting of:: positive growth effects at least in the near term; and an impact on inflation that varies depending on the balance of inflationary and disinflationary effects in each country, but that should be manageable overall without requiring meaningful deviations from currently expected monetary policy paths.
