9/15/22, 3:25 PM Economics lessons from the Ukraine war: expectations matter | Financial Times

Opinion  Free Lunch

Economics lessons from the Ukraine war: expectations matter
Kyiv’s counter-offensive, inflation and the Wizard of Oz

MARTIN SANDBU

Ukrainian troops drive on a bridge across the Siversky Donets river on Wednesday © Evgeniy Maloletka/AP

Martin Sandbu 4 HOURS AGO

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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
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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”.
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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
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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.

Other readables
• 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 ”
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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.

Numbers news
• 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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