The economic consequences of the new Cold War

Ukraine’s Crimean peninsula has effectively been annexed by Russia. There is unrest along Ukraine’s eastern borders, and the Russians may take control of that region as well. Referendums in that area, even though dismissed for their lack of rigour and flawed voting procedures, have stoked separatist sentiment even more.

On the other side, American troop levels have been increased in the Baltic States. And both the US and Europe have imposed sanctions on Russia, targeted especially at its long-serving president, Vladimir Putin.

It may be an exaggeration to describe all that as a new Cold War, and certainly the tension between East and West is not as bad as it was in the 1950s and 1960s. Even so, relations with Russia have turned distinctly hostile, and they are not likely to get better any time soon.

Another Cold War with Russia need not necessarily be catastrophic for the global economy. During the last one, the Western economies all did pretty well. Indeed, they did better before the Berlin Wall came down in 1989 than they did afterwards, although that was probably a coincidence.

There were lots of reasons why economies were growing more strongly in the 1950s and 1960s than they have done in the last two decades. But a renewed period of East-West tension will still fundamentally change the way the global economy operates. Here’s how.

First, spending on defence will start to rise. It is easy to forget how much we used to spend on our armed forces. In 1953, for example, it accounted for nearly a quarter of government spending (largely on account of the Korean War). Even in the early 1980s, it accounted for 12% of spending, compared with about 7% now. Even a mild increase in tension could easily see defence spending double.

That would be great for the arms industry, and all its spin-offs – and probably for the UK manufacturing sector as well, since we remain one of the world’s biggest defence exporters. But it would also put a lot of pressure on government budgets at a time when it cannot really be afforded.

Next, energy prices would go up. Europe imports the bulk of its gas, and a lot of its oil, from Russia. It supplies 40% of Germany’s gas, and 50% of Austria’s. If tensions escalate, that is gradually going to go into decline. True, there are other sources of supply, but if they are used instead then prices will inevitably rise.

Over the medium-term, tension with Russia might prompt Europe to finally start developing its vast reserves of shale gas – but that is going to take several years at least to come on stream. Until then, higher energy prices will hit already struggling economies across Europe.

Third, capital flows will start to decline. After the end of the Cold War, money started to move fluidly around the world at incredible speeds and in vast quantities. That was partly thanks to technology, but it was also because no one was putting any restrictions on it.

In a tense, divided world, money doesn’t flow as easily as it does in a peaceful one. There has already been a big drop in global holdings of US Treasuries since the Crimean crisis started.

No one quite knows why that is, but there has been speculation in the markets it was caused by Russian money getting out of America, because investors feared their assets might be frozen. That might continue or it might not, but it seems inevitable that capital will be a lot less mobile than it has been for the past 20 years. That will change the way asset markets work.

It will also make it harder for countries with big trade and budget deficits – such as the US and UK – to finance them, since there will not be as much foreign capital to draw on as there has been in the past. The globalisation of finance will come to an end.

Finally, strategically important states will get a lot more support. Take Greece, for example. Russia has always had a keen eye on the country, mainly for access to its ports on the Mediterranean.

During the Cold War, Greece could always count on support from the US and the rest of Nato to stop its falling into the hands of the pro-Moscow far-left. After the end of the Cold War, no one worried about that any more. But with the country still close to bankruptcy, the far-left Syriza Party is now ahead in the polls, and may win the next election.

If geopolitical rivalries are back, no one is going to let Greece fall into Moscow’s camp – it is too important. If it needs to be bailed out with more money, then so be it. The same is true of Turkey, which controls access to the Black Sea. And Egypt, with the Suez Canal.

Both countries have been through major economic shocks over the past few years without receiving much help. But now any nation of geostrategic significance will get bailed out, just as they did in the 1960s and 1970s.

The tension with Russia may blow over in a few months, with little more than a minor re-drawing of the borders with the Ukraine. If so, not much will have changed. And yet if there is a long, sustained period of growing hostility between Putin and the West, that will ultimately have a huge impact on the economy.

Some of it will be for the better – but much of it will be very expensive, and will add to the challenges facing economies that are already struggling.

Merryn

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