Linking Geopolitics to the Macroeconomy
With the ongoing war in Ukraine, the conflict in Israel and Gaza, and the Houthi attacks on shipping in the Red Sea, geopolitical risk has come to the fore in our thinking about risks to the UK economy. Deputy Director for Macroeconomic Modelling and Forecasting, Stephen Millard talks to Jens Larsen, Director of Global Macro-Geoeconomics at Eurasia Group, about his thoughts on geopolitical risk and its link to the macroeconomy.
Much is spoken of ‘geopolitical risks’ but what are the links between politics and the macroeconomy?
No one would dispute that economic policy matters—be it fiscal, monetary, microeconomic policies, or the latest fashion, industrial strategies. Most would also subscribe to the view that for individual countries, the stability and quality of the legal, political, and economic systems matter for macroeconomic performance, even if the exact link is uncertain. There is a growing literature that shows that populist governments are associated with poor growth outcomes; and evidence that poor growth and high inflation have political consequences, weakening incumbent governments that face elections.
Geopolitical risks are a little harder – the direct impact is less obvious but there is evidence that high geopolitical uncertainty creates uncertainty, and that episodes of heightened uncertainty are associated with lower investment and employment. The potential channels include some direct channels, most obviously in the cases where geopolitical risks have a direct bearing on commodity prices or the trade environment – the massive impact in 2022 of Russia’s invasion of Ukraine is a case in point. But the impact could be more subtle – creating a more uncertain and less investment-friendly environment in the short term and undermining the prospect for increasing trade and financial integration in the long term. Arguably, the strategic tension between the US and China is one of the defining geopolitical conflicts of our times, with a significant impact on investment, trade and ultimately on growth.
How might you go about assessing geopolitical risks and their possible effects on the macroeconomy?
There are useful indicators of geopolitical risks and uncertainty that can underpin the intuition that elevated geopolitical risk is bad for growth, investment, and employment; they help establish a statistical link between politics and the macroeconomic outlook. But most of these suffer from being summary measures that are backward looking by construction, and that do not help much for an analyst who is trying to think of future impact.
As always, we need to try to disentangle the likely source of the shock – what is driving geopolitical risks – and the political and economic transmission channels – how might an event translate into political responses that in turn trigger economically meaningful events or outcomes. To give an example: how might this year’s elections in the US unfold? What policy responses might a new administration implement? How will other governments respond? How will that affect the short- and longer-term economic outlook?
To address such issues, I think we need a combination of comprehensive intelligence gathering, strong analysis, and of course a framework that can help us map that analysis into economic outcomes. That framework needs to be broader than a standard macroeconomic model. Models such as NiGEM are still critical when putting together a coherent forecast; macroeconomic models are not redundant. But to incorporate political risk and geopolitics, we need a broader approach that draws extensively on other social sciences, in particular political science, and other sources of information than the standard macroeconomic data.
What are the current top geopolitical risks?
We at Eurasia Group published our Top Risks for 2024 in early January. In the overview, we call 2024 a political “Voldemort of years”, just to give you an idea of where we are going….
The list is topped by three conflicts: that includes the Middle East on the brink, and the conflict in Russia-Ukraine where we think Ukraine may need to accept a de-facto portioning in 2024. But the list is topped by the United States versus itself – 2024 will present massive challenges to US democracy, and the US and the rest of the world face the very real prospect of a second Trump presidency. Related to those risks, we are worried about the increasing alignment between rogue geopolitical players—Russia, Iran, and North Korea.
All of these events could have important macroeconomic ramifications: we witnessed the impact of the Russia-Ukraine crisis on commodity prices last year; the crisis in the MENA region is laden with escalation risks that might spill over into a broader regional conflict; and a contested US election or a Trump 2.0 could change the course of the US and global security and economic structures.
We also have a number of risks that – to my mind – pose structural economic risks. That includes: AI governance, critical minerals supplies and climate risks in year of a powerful El Nino climate pattern.
When we pull all that together, we see a year of continued sub-par growth and persistent inflationary pressures, even if the intense inflation crisis of early 2023 is receding; importantly, there is little space for accommodative macro policy if economic growth deteriorates. The geopolitical crises are an important contributing factor, dampening the current growth outlook through heightened uncertainty, but also anchoring less growth-supportive long-term economic outcomes.
Concentrating on events in the Middle East, what do you see as the likely effects of this on the UK economy?
The most obvious channel is if oil prices were to increase sharply as a consequence of a conflict escalating to impact the supply of oil; that would immediately re-ignite inflation and put pressure on incomes and growth. As we saw last year, such terms-of-trade shocks can be highly disruptive, and even the risk of such a shock will have an impact. That said, we still see that as a low probability outcome. A much more likely outcome is the sort of disruptive impact on trade in goods and commodities associated with the Houthi’s attack on shipping in the Red Sea that we are currently seeing: that dislocates traffic, increases the costs of transport and traded goods, and raises the risk of supply disruptions.
In my view, the direct impact on the UK economy is likely to be limited; even if the crisis worsens, the impact is unlikely to be as material as we experienced in 2022-2023 as a consequence of Russia’s invasion of Ukraine and the subsequent restrictions on energy supply.
But these are only the most obvious economic risks – the heightened geopolitical risk that the crisis creates is harder to quantify but is likely to have an impact on investment and trade, most obviously in the region but also more broadly. For a globally exposed UK economy, these effects could well turn out to be important.