Economics lessons from the Ukraine war: expectations matter
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There are few things more heartening than the comeuppance of a brute, especially when that comeuppance liberates thousands of people from the brute’s ability to terrorise them. But Ukraine’s exhilarating advance on the battlefield in the past week or so carries lessons beyond the satisfaction of good’s victory over evil.
I remember well conversations in the first days after President Vladimir Putin’s attack about whether to arm Ukraine’s government. A common view was that because the country was bound to be overrun by Russia’s army in a matter of days, sending arms would only make things worse by encouraging a permanent but permanently doomed guerrilla effort: “a new Afghanistan on our doorsteps” as some put it. In these conversations I insisted that even those who expected Ukraine to lose at least owed them a chance at defending their country. Fortunately, the Ukrainians’ bravery and fighting prowess stopped the assault on Kyiv fast and spectacularly enough to rally more western support. That support made this month’s counter-offensive possible.
Expectations about what will happen play a deep role in what actually does happen. Ukraine’s stout defence in the battle for Kyiv, by confounding expectations of a quick defeat, made the political winds shift in the west. This month’s counter-offensive, by confounding western expectations of a dragged-out positional war, has shifted them again. Already, as my colleague Henry Foy reports, the view is taking hold that better and faster weapons delivery could hasten rather than delay an end to the war, and a better end at that. Western countries are now said to be discussing providing Kyiv with fighter aircraft, a move that was previously rejected as too likely to provoke Putin.
If these expectations had shifted earlier, or shifted more, it was likely that Ukraine would have been given more military aid sooner. Its defence and counter-attacks would then have been even more impressive, thus validating those very expectations. Conversely, if those who argued Ukraine didn’t stand a chance had won the rhetorical battle, the effects of such a victory may well have proved them right in the real war too.
Politicians know this function of expectations very well. Putin, always the spy, has presided over information warfare against the west for as long as he has been in power. His success (on which he has spent significant amounts of money) can be measured in the shocking number of otherwise thoughtful people around the world who seem content to lay the ultimate blame for torture and rapes in Bucha and elsewhere at the door of western democracies. From the start of the war Volodymyr Zelenskyy, Putin’s opposite in so many ways, grasped the importance of shaping a domestic and international narrative, and his excellence in communication has added to the bravery and organisational skill of Ukrainians on the ground.
Economists have an analogous, if less refined, understanding of expectations. Game theory, which analyses interactive economic situations, shows how people’s behaviour can be shaped by their expectations of the behaviour of others in such a way that expectations become self-fulfilling. Under certain conditions, if everyone expects the bad outcome to occur, it does; and if everyone expects things to work out better, they do — all because of the actions people choose given what they expect others to do. Financial price fluctuations can exhibit this pattern. So can demand-led economic cycles driven, as Keynes put it, by “animal spirits”.
Lift the gaze up from narrow models, and self-fulfilling expectations help make sense of large-scale phenomena. Five years ago, I wrote about economics Nobel laureate Robert Shiller’s work on “narrative epidemics” and how when shared stories take hold of enough people’s minds, they change reality itself. One example back then was how the election of Donald Trump — a master of storytelling if nothing else — prompted a boost to economic sentiment among his supporters, which probably kept the economy humming along nicely.
So here is one similarity between war and the economy. Because expectations matter, both are profoundly unpredictable. And neither is fully determined by “hard” factors but influenced by mass psychology.
Take today’s energy prices. These are, in part, based not just on current physical constraints but on the expectations of those trading in the financial hedging markets for prices in the future. Nobody has any idea whether next year’s physical energy markets will match what financial traders expect today. But those expectations influence the prices companies and consumers pay for physical energy today. And if those expectations change — for example, from signs of government intervention, or as the fact of Europe’s rapidly filling gas reservoirs sinks in — so could the nature of the energy price crisis, even with little immediate change in the physical constraints.
As my colleague Gillian Tett recently pointed out, Shiller’s insights also apply to central banking. The debate on inflation boils down to whether people will start expecting current inflation to persist — and, therefore, cause it to persist by driving up wages and prices further. The few of us who think central banks are wrong to kill our current strong jobs growth point to how longer-term inflation expectations remain quiescent. The majority that supports tightening thinks that because the economy is overheating, only tightening can prevent expectations from shifting up (even when they agree that no tightening would be necessary if inflation only reflects one-off supply shocks).
But, in one way, central bankers face a trade-off that Ukraine’s army doesn’t. Ukraine can change expectations for the better by changing the situation on the ground for the better. Central bankers’ chosen strategy for changing inflation expectations for the better, however, causes harm to the economy by killing job and income growth. If instead they can convince people that inflation will go away by itself as supply shocks fade away, they will not have to cause harm to the economy in the process. My own view is that because that is indeed what people seem to expect, it is a gross policy error to make borrowing costlier.
Consider, then, how Ukraine’s military success may shape expectations in Russia. One of the books I read as a student that I remember best is Étienne de La Boétie’s Discourse on Voluntary Servitude, which points out that a dictator can only have power over others insofar as they choose to obey him or her. In pure physical terms, an individual could never dominate a nation, but dictatorship is possible through a network of self-reinforcing fears that those who rebel will be punished. That is why revolutions, when they happen, happen so fast, or why once taboos are broken, they are hard to restore. When enough people stop expecting enough others to comply, reasons evaporate for anyone to comply at all. Call it the Wizard of Oz theory of power: once the expectation of enforcement falls away, so does any ability to enforce.
The most intriguing impact of Ukraine’s recent victories, therefore, is in Moscow. Explicit dissent against the war seems to have broken out (as has the open use of the taboo word “war”), from critical talk show guests to municipal officials calling for Putin’s impeachment. This may matter, or it may not. But we won’t know how many Russians would oppose the war if they did not expect to be punished for it until enough Russians no longer expect to be punished for it. The widespread belief that it is possible to oppose a dictator has a way of making just that happen. If Ukrainians keep succeeding as they have, things could change much faster in Russia than we think.
In another effect of changed expectations, I write in my column this week that Vladimir Putin has forced the EU into the energy union it should have built long ago.
As you will know from last week’s Free Lunch (and several more before), I take a deep interest in wealth taxes. So I was intrigued to learn from new research on more than a hundred years of German wealth inequality that the country imposed a large one-off tax on wealth in 1948. “Owing to this wealth tax, Germany became one of the most equal countries before her postwar economic miracle took off,” the researchers say.
Expect more stories like this one: durable goods manufacturers — in this case, Electrolux — facing a double whammy from retrenching consumers and overstocked inventories from back when nobody could get enough of industrial goods.
The UK economy is flatlining. But maybe inflation is, too.
Overall US inflation was only 0.1 per cent month on month in August, thanks to falling energy prices. Outside of energy, however, core inflation rose 0.6 per cent, or more than 6 per cent on an annualised basis.
The Guardian offers an explainer of the UK royal family’s finances.
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