Western policymakers’ and investors’ long-standing assumptions about Europe’s geopolitical and economic order are being shattered one by one, with major implications for the EU and the euro area. I see value in thinking through alternative scenarios of what this may mean for Western Europe and the euro area, specifically. Below, I outline four potential pathways, but with the caveat that the sheer unpredictability of events makes it impossible to put credible probabilities on any of them.

A Changed World
Whichever road we end up taking, there is no going back to where we were before the invasion. I think the world has now changed in the following ways:

• This is the start of another explicit Cold War. Economically, I think that accelerates the trend toward deglobalization of energy as well as supply chains, which will inevitably mean higher costs.
• The euro area’s fiscal strategy has shifted. Whatever the eventual outcome, fiscal spending will be structurally higher. The question is simply one of degree.
• The Western sanctions policy toolkit included switching Russia off SWIFT—a move initially resisted by the EU—and freezing central-bank reserves. All countries will have registered that threat.
  
  

The question we need to answer is whether these three shifts are happening in an environment of demand destruction or not.

We should also beware of false probabilities. The paths I describe below are not mutually exclusive. In fact, the realization of one scenario may first require a sharp rise in the probability of the opposite path. For instance, the world may need to get close to the edge before any de-escalation is possible. That makes investing with any level of conviction incredibly difficult, as the signposts that would signal confidence could be misleading.

Four Potential Paths
1. Stalemate — My base case is that we are heading for a stalemate and a Cold War. This would involve Russia taking over Ukraine, but Ukrainians continuing to resist, funded and aided by the West. The sanctions would persist and harden further, with Russia seeking economic commitments from elsewhere. This would be an unstable equilibrium, with increased NATO presence in Europe and numerous opportunities for flare-ups.

The near-term economic implications for Western Europe would be much lower growth (-1%) and much higher inflation (+2%). Under that scenario, the European Central Bank (ECB) would slow, but not stop, the process of hiking interest rates later this year. However, stalemate would, in my view, entail a sharp acceleration toward a more fractured world, with more explicit deglobalization. That process would be funded by permanently higher fiscal deficits. This stalemate outcome could slow the exit of the ECB and other central banks from ultra-loose monetary policy and may raise nominal growth and inflation even further in the medium term. The key risk to this view is if the migration flows from Ukraine accelerate so much (10%+ of the population) that they meaningfully increase the euro area’s labor force, which could dampen wage growth. From a yield perspective, the long-term equilibrium interest rate may be unchanged or lower, but that fall should be offset by higher inflation expectations and higher risk premia.