Geopolitical risk in the euro area: measurement and transmission
Summary
Focus
Geopolitical risk (GPR) has become a key driver of macroeconomic and financial developments, with the euro area particularly exposed since the war in Ukraine and, more recently, the conflicts in the Middle East. Yet widely used measures predominantly reflect an Anglosphere perspective, especially a US-centric one, because they are constructed from English-language sources. However, geopolitical risk perceptions depend on a region's exposure to and stake in a given conflict. Against this background, we develop a euro area-specific approach to measuring GPR and provide a comprehensive framework to analyse its consequences for economic activity, inflation and monetary policy.
Contribution
We construct new euro area GPR indicators based on local European newspapers at monthly and daily frequencies. The indicators diverge from Anglosphere measures, especially since 2022. To assess their macroeconomic implications, we estimate a Covid-19-adjusted vector autoregression (VAR) for the euro area, allowing us to analyse a long pre-pandemic sample alongside recent geopolitical events within a consistent framework. We compare shocks identified using the euro area GPR measure with those obtained from an Anglosphere GPR measure and quantify the macroeconomic costs of the war in Ukraine through a "No-War" counterfactual that holds GPR at its December 2021 level. We also assess euro area prospects amid current Middle East conflicts by combining end-of-sample nowcasting with structural scenario analysis. Finally, we complement the analysis with two news-based euro area measures of sanctions intensity and shortages.
Findings
A euro area GPR shock lowers economic activity and raises prices in the euro area, consistent with an adverse supply-type shock. Monetary policy responds by raising rates. We show that the measurement of regional GPR is essential for economic inference, as using an Anglosphere measure understates these effects for the euro area and can even mask the contraction in production. Relative to a "No-War" counterfactual, the war in Ukraine led to notable costs in the euro area by mid-2022, with lower industrial production and heightened inflation. Forward-looking scenarios for the Middle East conflicts show that the euro area outlook is highly sensitive to the path of GPR: escalation and rapid de-escalation generate substantially different trajectories for production and inflation.
Abstract
Geopolitical risk is a major concern for the euro area, yet widely used measures largely reflect a US perspective. We introduce a geopolitical risk indicator tailored to the euro area using local European news sources. Shocks to this index have significant recessionary and inflationary consequences in the euro area, effects that would be missed when relying on the corresponding US-based measure. We estimate that the war in Ukraine imposed substantial output losses and inflationary pressures on the euro area in 2022. Combining structural scenario analysis with end-of-sample nowcasting, we show that euro area prospects are highly sensitive to future developments in geopolitical risk. We complement these analyses with two news-based measures of sanctions intensity and shortages for the euro area.
JEL classification: E31, E32, F42, F51
Keywords: euro area, geopolitical risk, inflation, sanctions, shortages
