A view from London

It might seem strange that last Friday’s Israeli missile strike against Iran was greeted with relief in the West, but the attack was at the low end of the range of possible responses. In a world of elevated geopolitical risk the limited nature of the Israeli strike was, in the jargon, ‘de-escalatory’.  

Tensions in the Middle East and the conflict in Gaza coincide with a full-scale war in Ukraine and the resurgence of superpower competition, with the West at loggerheads with Russia and, increasingly, China.

Geopolitical risk is back. The Economist Intelligence Unit estimates that 75% of countries are threatened economically by international tensions today, up from about half in 2010. Military spending is on the rise across the world. The US and China increasingly vote on different sides in the UN. A near tripling in the number of countries subject to western financial sanctions since 2010 testifies to growing international discord.

UK chief financial officers responding to the Deloitte CFO Survey say that geopolitics poses the greatest risk to their businesses over the next 12 months, eclipsing worries about inflation and interest rates.  

Geopolitical risk is not homogenous. It comprises a range of related and unrelated events. In thinking about geopolitical risk we need to distinguish between the social and political consequences and wider economic effects, beyond the region.

Geopolitical shocks are not necessarily economic shocks – at least at a global level. The effects on the local or national economy, as in Ukraine or Gaza, can be devastating. Surrounding countries may also be affected, as, for instance, has been the case with Egypt, where revenues from tourism and the Suez Canal have been hit by the conflict in Gaza.

But the impact beyond the region may be limited or transient. The 9/11 terrorist attack was one of the greatest geopolitical shocks of the post-war period. It triggered US-led invasions of Afghanistan and Iraq, lengthy wars and major political changes in the Middle East. Yet it had little lasting economic impact on the West.

Contrast this with the impact on Europe of Russia’s invasion of Ukraine. Here energy and other commodity prices and the curtailing of Russian gas exports were the transmission mechanism that turned the invasion into an economic crisis for Europe. The result was high inflation and a weakening of activity, particularly in Germany.

Energy was also the channel through which the Arab-Israel war of 1973 became a global economic crisis. In response to the US providing military support to Israel, Arab producers imposed an embargo on oil exports. It led to a nearly fourfold rise in oil prices and resulted in much of the West, including the US, Japan and the UK, falling into recession. Spikes in oil prices were also seen following the Iranian revolution in 1979 and the invasion of Kuwait in 1990, both of which also preceded recessions in the West.

Geopolitical shocks that affect supply, prices or trade have the greatest capacity to wreak wider economic damage. Examples include Houthi attacks on shipping in the Red Sea, potential disruption to semi-conductor exports from Taiwan or the control of rare earth metal exports.

Financial markets provide another channel through which geopolitical shocks can cause economic damage. Abrupt movements of mobile capital weaken currencies, cause destabilising fluctuations in equity and other financial markets and affect the supply of liquidity and credit. Emerging economies are more vulnerable to such effects than advanced economies, though the latter are not immune. (The 9/11 attacks, while having little lasting economic impact, resulted in the closure of the US equity markets for the rest of the week, an inability to clear cheques because of the suspension of flights and soaring demand for cash.)

This is not just about shocks. More gradual geopolitical shifts can have significant economic effects too. Rising international tensions have contributed to a weakening of cross-border capital flows and investment and created a more difficult climate for trade. Just as the economic liberalisation of the 1980s to early 2000s helped drive global growth, today’s economic distancing is acting as a drag on activity. 

The post-cold war era of consensus in the late 1990s and early 2000s now seems like a short interlude from the geopolitical rivalries of most of the 20th century. America was the principal architect and guarantor of the post-war international order. But, at least in relative terms, America is a declining economic power. This speaks to a world where geopolitical risk is likely to remain elevated.

In one key respect things have improved. The world is better placed to deal with disruption to energy supply than in the past. Energy markets are more efficient, integrated and contestable than they were in the 1970s. Shale fracking has led to a huge increase in US energy production, weakening OPEC’s hold over supply. Consumer nations now have petroleum reserves that can be used to protect against shortages. Renewable energy production is rising.

All these factors – along with huge levels of government subsidies – mean that the economic fallout from energy following Russia’s invasion of Ukraine was far less severe than had been feared. (At the time a severe recession seemed quite likely.) Europe switched remarkably quickly from Russia to imported liquefied natural gas from the US, the Middle East and Australia.

Systems and economies are adaptable and responsive. In many respects they have proved surprisingly resilient in the face of the multiple shocks of the last decade or so. Geopolitical risk is unlikely to abate. The need is to be prepared for it.