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Erik Berglof, Director of the Institute for Global Affairs at the London School of Economics recently argued that twenty-five years after the fall of the Berlin Wall, new divisions are becoming apparent on the European continent. According to him, this is likely to impose significant costs. In doing so, it threatens to reverse the so-called peace dividend which Europeans have come to take for granted over the past quarter century.
Lower defense expenditures, paired with the normalization of trade and investment flows, have helped many countries in emerging Europe not only get through very difficult recessions in the early 1990s, but also helped them weather the spillovers from the Russian financial crisis in 1998.
According to IMF, fiscal consolidation in Central and Eastern Europe after the global financial crisis was facilitated by yearly defense savings of at least 1-2% of GDP, compared to what these countries would have had to spend had they not been NATO members.
Alas, that peace dividend, crucial as it proved to be during the long years of economic transformation, has now become more of a burden–as a geopolitical tax. That tax, thankfully, is not yet at the Cold War levels they were used to, but it is still bound to be substantial. Russia sets the pace. It is now spending at least 5% of its GDP on defense and Ukraine has announced that it wants to double defense spending relative to GDP, to also reach the 4-5% range by 2020.
Many of the new NATO members in emerging Europe, who until now have essentially been free-riding on the alliance’s collective defense commitment, have declared their aim to meet the 2% obligation for the defense budget. These increases may seem small, but are significant, especially given the widespread tightness of public spending.
According to Erik Berglof, the new divisions seizing Europe are once again beginning to distort trade and investment. Most immediately, this manifests itself through sanctions and counter-sanctions, but the spillovers to non-targeted sectors and individuals are very real. What economists call “aggregate or systematic uncertainty,” or uncertainty about the rules of the game, is clearly on the rise.
This “geopolitical tax” is not limited to the trade and defense arenas. It also shows up in the increasing emphasis of redundancy in the various key systems which the modern economy relies on, most notably in the financial sector, but also in energy.
IMF has insisted that no one in Europe needs to be reminded of the renewed importance of energy security. Energy security has always been very important in the minds of policymakers in emerging Europe. These concerns demand security for production countries as well as supply security for the importing countries. Increasingly, European countries are seen as keen on trying to diversify their supply channels. The problem is that national responses are often highly inefficient and sometimes directly counterproductive.
As Erik Berglof stated, what Europeans need are responses at the regional level and potentially even at the global level. In practical terms, that means investing in better interconnections between various national systems and encouraging much more cross-border cooperation in the energy area. The new European Commissions commitment to pursuing an energy union is highly encouraging.
Erik Berglof, argued that progress on this crucial front will be costly, as huge investments are needed in the energy sector, and not only in emerging Europe. The Paris-based IEA has estimated the investment need to add up to $2 trillion over the next 20 years, with two-thirds of that amount expected to be needed in emerging markets.
To be clear, the current geopolitical uncertainty is not helping reduce overall risk levels. Irrespective of that fact, energy projects do have their own specific risks. The main problem is not the availability of finance, but the pipeline of well-prepared, bankable projects. Two factors stand out in this regard. First, the absorption capacity of emerging markets is not yet sufficient. And second, it is often difficult to encourage bidders to invest in project preparation when they do not know whether they will win tenders or not.
The biggest constraint, though, is often policy risk, or, more specifically, the risks associated with political volatility and changes in the legal and regulatory frameworks. They are highest in emerging markets, but they are also considerable in advanced economies.
One crucial issue in this regard is the role of the International Financial Institutions. International financial institutions can play a vital role in helping to mitigate these risks. They do so mainly by providing “political cover” for investment projects. However valuable that is, it is important to realize that such a cover cannot provide an ironclad guarantee.
Viewed over the medium and long term, the main contribution of International financial institutions is their capacity to promote reforms and help improve the general business environment. Unfortunately, the record in emerging Europe is mixed. For an entire decade now, much of the region has been held back by a lack of reform. Countries are “stuck in transition,” often as a result of weak political institutions and strong vested interests.
Economic analysts stated that while the main responsibility for reform is a domestic one, International financial institutions can help countries get out of these traps by working with private sector partners and governments. They can also promote regional solutions by encouraging the interconnectedness of energy systems and coordinating investments in storage facilities.
That is one more reason why energy security will become ever more important for International financial institutions. As geopolitical tensions escalate in Europe, and as the costs associated with those tensions become more taxing, it is all the more imperative to manage the underlying risks in a manner that is both future-oriented and sustainable.
There are no guarantees, but the renewed emphasis on energy security could provide a new momentum for integration within the European Union. The reforms needed to secure stability in energy supply will also help perfect the individual markets still suffering from the scars left by the global financial crisis.
What is crucial for the long-term prosperity of Europe is that such deeper integration does not result in new barriers being erected towards the east. Europe and Russia need each other, and the current geopolitical tax is imposed on both.