A Treasury note has warned the long-term consequences of the war in Ukraine could be with the world for a long time in the form of lower growth, higher food prices, more government spending and
high inflation.

The paper warned the authors’ baseline scenario is that the war would continue the rollback of globalisation the world has experienced since the end of the Cold War, resulting in a period of higher costs and uncertainty.

This would put “stress” on public balance sheets as governments are forced to respond to increased spending on security, climate change, and an ageing population whilst balancing the challenge of propping up people’s declining living standards.

Structurally higher inflation and possibly interest rates would lead to a “painful and possibly disruptive” decline in asset prices – likely housing.

“On balance we believe we will be faced with a more fractured world, both geopolitically and in terms of economic systems and governance.

“Such a world is likely to be riskier for policymakers and businesses alike,” the paper warned.

The paper looked at the long-term consequences of the war in Ukraine. It was co-authored by eight Treasury staff and represented their views and not the views of Treasury itself. The paper was published last month and recently released on Treasury’s website.

The authors said growth would probably be “lower” while ” inflation and interest rates higher”.

The combination of higher inflation and interest rates would make spending decisions more difficult, as it would raise the cost of each investment.

The authors warned that this would make the financing and trade-offs involved in climate change adaptation and mitigation “more acute”.

People’s wellbeing in the future would be “similarly negatively impacted”.

The paper paints a picture of a more uncertain world – one very different to the last 30 years.

“[M]any of the underlying economic (and political) forces operating over the past few decades are likely to go into reverse,” the paper said.

This would result in the “global economy being driven by a different set of macro conditions and priorities, with the period ahead likely to be marked by a number of transitions”.

Perhaps the biggest trend is the retreat from globalisation, which the authors feared would result in long-term higher costs, which would lead to long-term higher costs and higher inflation.

A retreat from globalisation

The most striking conclusion of the paper is the authors’ “central scenario” that the war will “exacerbate the retreat from globalisation”.

“Globalisation” would shift to “regionalisation”, which could “increase production costs and drive-up global inflation and interest rates”.

Global supplies of both labour and energy could become more scarce and accessible to New Zealand, pushing up energy and labour costs.

Capital investment could become more difficult to source, and the government’s finances could come under pressure as it is forced to increase spending both on the military and national security, and on propping up people’s flagging living standards, which could decline as the cost of nearly everything increases.

Higher inflation and interest rates

One consequence of this retreat from globalisation would be higher inflation and interest rates.

Globalisation, particularly the increased “access to China’s cheaply produced goods” had helped to keep inflation low this past decade.

“China’s abundance of savings also contributed to a secular decline in interest rates,” the authors said.

This was put under threat by a retreat from globalisation.

If the world trading system “fragments” it could see supply chains pivot from low-cost “just-in-time” to high-cost “just-in-case” models.

This would push up costs.

It could “prompt a long period of higher inflationary pressure, requiring central banks to keep interest rates higher than we became used to over the past decade”.

A sense of “increased risk aversion” could push interest rates higher because investors would want greater returns for the greater risk they were taking on.

Also putting pressure on interest rates would be greater fiscal deficits run by governments, as they were forced to increase spending to support living standards without raising tax.

This would be on top of the challenge already faced by governments as they grapple with ageing populations and climate change.

If central banks acted too slowly to respond, the authors warned inflation “could remain at elevated levels for an extended period”.

This could put “stress on government balance sheets” and cause a “painful and possibly disruptive” collapse in asset prices – although the authors did not single out the housing market, it is likely this is the market that would be the hardest hit.

The paper said that asset prices had been “pumped up in recent decades by steadily falling interest rates”.

One silver lining is that higher interest rates would give more room to cut rates in future, if the economic cycle required them.

Politics

The authors think there are both more and less benign versions of this scenario.

The most grim is that the war could “represent more of a ‘tipping point’ or ‘rupture’ for geopolitics and the global economy”.

In this scenario “[t]ensions between political and economic blocks would be much increased”.

“Countries could come under pressure to ‘choose a side’ and face an increased prospect of economic coercion to influence a government’s decisions,” the paper said.

Although the authors do not mention it, this scenario could be difficult for New Zealand which might face difficult decisions forced by the tension between its major trading partner, China, and its historic security partners, the United States and other Five Eyes countries.

Another scenario was more optimistic.

“[I]f the Ukraine conflict can be quarantined enough (and Russia sufficiently isolated) to avoid broader geopolitical and economic ruptures an outcome similar to the current status quo may be possible, albeit still with some reversal of the economic drivers of the past 30 years,” the paper said.

In this scenario countries could still work together in areas like climate change and other areas where international co-operation is necessary to achieve the desired outcomes.

Slower economic growth

Globally, economic growth forecasts have been “pared back materially”, particularly in the conflict region, Europe, and commodity importing countries.

However, even New Zealand was seeing growth forecasts cut as the war “dents consumers’ wallets via higher oil and food prices”.

The authors reckoned this would harm pandemic recovery, ” keeping economic activity below the pre-pandemic trend in many countries”.

New Zealand, as a food exporting country, stands to benefit somewhat from the conflict, which will push up the cost of food.

However, these benefits would be offset by higher import costs.

Households will lose out long-term from higher overall costs and New Zealand’s weakening currency.

“While some exporters may benefit, consumers will be bearing the cost of higher food prices, particularly those on lower incomes for whom food makes up a larger proportion of the household budget.

“In addition, the recent fall in the exchange rate makes imports more expensive for producers and consumers,” the paper said.