Psychological effects can be more ambiguous. People might, for example, be inspired to work harder to support the war effort or depressed and discouraged by the loss of loved ones. Innovation effects are similarly ambiguous. There might be more innovation in respect of outputs required for the war effort, but innovation in areas of broader economic value might be more limited. There is often inflation as ordinary goods become scarcer, but there is full employment. Trade deficits often soar, but sometimes countries build lasting alliances and attract foreign financial aid, along with investment support from their disasporas and sympathetic foreign investors.
Many of these effects are visible in the cases of Ukraine and Russia. Ukrainian output fell dramatically at the start of the war, with GDP down about 30 percent in 2022. Potential output is currently about 20 percent below its pre-war level owing to the occupation of land and the destruction of infrastructure, not only through bombs, missiles and artillery but also through the devastating floods created by the collapse of the Kakhovka Dam. At times, Ukraine’s energy supply has dropped by as much as 40 percent as a consequence of Russian attacks. Yet Ukraine’s economy is now growing fairly rapidly, as it adjusts, recovers and makes use of foreign funds. In 2023 GDP grew nearly 6 percent and 4 percent growth is expected in 2024.
Ukraine is unsurprisingly running a large trade deficit, partly because of the loss of metals exporting operations that were based in now-occupied zones and disruption to cereals production and transport, but also as a side-effect of massive financial inflows as foreign governments and investors rushed to provide Ukraine with financial support. Having chosen to fix the exchange rate at the start of the war, then engage in a rather large currency devaluation in mid-2022, the central bank shifted to a floating exchange rate in 2023, making current account balances less challenging to manage. Inflation, which had peaked at over 25 percent is now down to closer to 5 percent.
Ukraine’s government debt to GDP ratio is expected to rise to about 100 percent in the coming years, with defence spending now more than sixteen times as high as it was pre-war. Ukraine’s foreign lenders have chosen a deliberate and pre-emptive policy of forbearance, which should make these debt levels manageable for some time. Ukraine remains highly dependent upon foreign assistance. Should the willingness of key foreign financial supporters in the EU and US to support Ukraine financially decline, its economy could rapidly get into trouble.
Russia’s economy has been much less directly affected by the war than Ukraine’s, of course. Russian territory is not occupied. Relatively little Russian infrastructure has been destroyed. And the proportion of the Russian population redirected from working to fighting is much lower. The war has also been associated with a rise in the price of energy and certain Russian energy output, such as oil, have been selling at higher prices. However, the overall effects on the Russian economy have been unambiguously and sharply negative. Russia has lost revenues on its gas supplies to Europe — long-term losses that will never be recovered. Goods and services sanctions have damaged its exports and imports, with its attempts to circumvent such sanctions via China and non-aligned countries having some success but by their nature being a greatly inferior alternative to the Western markets from which Russia is now excluded. Financial sanctions have severely damaged Russian wealth, with Russia defaulting on part of its foreign debt in 2022. Russia has also experienced significant personnel flight, with people fleeing conscription, economic distress and political oppression.
Economic mobilisation for the war effort has had the usual short-term impacts of reducing unemployment (now down to close to 3 percent) and increasing output in military-outputs-connected industries, whilst inflation has created problems for Russian consumers that were manageable. Concerns about the risk of Russian bank runs petered out quickly.
Instead, the Russian economy faces something closer to the economic situation one might have expected had its 2022 invasion been rapidly successful. Whereas for most of the two decades from the late 1990s to 2022 Russia’s economy grew rather rapidly, partly through oil and gas wealth off the back of a phase of recovery as it adjusted to a more capitalist format, with living standards roughly tripling, its outlook now is now for much slower economic growth for the foreseeable future, making it increasingly challenging to manage its now rather high defence spending of around 6 percent of GDP.
Russia may still be hoping to make enough territorial gains in Ukraine that it could return some of those gains to Ukraine in a peace treaty in exchange for a relaxation of Western economic sanctions. Perhaps recent military developments suggest that is yet possible. Beyond that, however, it now has no straightforward way back into the global economy over the long-term and the economic consequences will mount even if it does not suffer military set-backs in Ukraine, potentially over decades if the Russian economy does not become over-stretched by its military efforts before then.
Thus the war is proving highly economically challenging to both Ukraine and Russia, albeit in different ways. Will Western resolve to support Ukraine falter before Russia’s ability to maintain its war economy? Will Russia or Ukraine achieve enough on the battlefield to allow some normalisation of their economic situations? Or will matters grind on, with negative economic, as well as social, consequences for many years to come?