How Ukraine sets its monetary policy in wartime — opinion

Few economic policy decisions do not involve an agonizing choice. Indeed, economics is built on appreciating trade-offs, binding constraints, costs, and benefits.

Furthermore, macroeconomists do not have parallel histories where one can compare outcomes of various alternatives. As a result, we never know for sure what could have worked better. This combined with the pressure to act, limited real-time information and complex linkages in the economy gives one an idea of the challenges faced by central bankers.

For example, if the central bank prints more money, it can help to pay for defense needs. On the other hand, this will generate inflation. The central bank can fix the exchange rate to control inflation expectations. However, this means that the central bank may have to burn reserves that may be needed later to pay for critical imports such as energy and weapons. The central bank can force commercial banks to buy government bonds at low interest rates (financial repression) but this means that the rest of the economy receives fewer loans and grows more slowly. The central bank can raise interest rates to fight inflation, but this means a slowdown in the economy. Expending reserves to defend the currency is costly but this could benefit the broader economy.

Now put yourself in the shoes of the central bank. Where would you draw a line when you determine “acceptable” inflation? How can one make this decision when reliable information about the state of the economy is not available? What if you do not know how—and perhaps even if—a policy can achieve the desired effect? In other words, how do you achieve an “acceptable” rate of inflation?

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These are very difficult questions, and these are the questions that the National Bank of Ukraine (NBU) had to answer. Could devaluating the hryvnia [national currency] stimulate exports? Yes. Is this likely to happen when Ukrainian sea ports are blocked by Russia? No. Could the NBU have lower interest rates in 2022 to help the economy? Yes. Would this bring inflation down? No. Could the hryvnia [exchange rate] have been allowed to float earlier? Yes. Would the success of this operation be guaranteed? Certainly not. Could the central bank maintain smaller reserves? Yes. Would these smaller reserves be enough to smooth irregular transfers of economic aid from Ukraine’s allies? Not clear at all.

Answers to these basic questions are of vital importance. But we should understand the limits of what we know. Hardly any country in modern history had to operate in the conditions that Ukraine faces now. There is no proven “cookbook” to deal with Ukraine’s challenges. Applying peacetime criteria to a wartime economy could be a most dangerous exercise. It does not mean that economics is useless—we have a lot of experience from previous wars, and we can use models to simulate alternative scenarios and assumptions—but we should certainly show humility and recognize enormous uncertainty in the outcomes of possible policy recommendations. In this largely unchartered territory, the central bank must look at the balance of risks, net effects, and multiple horizons as well as to probe and experiment to determine what tools are effective.

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Could the National Bank of Ukraine and the government have done better? Almost surely. There is no limit to perfection, and we have to be constantly thinking about “what if” to come up with better solutions. But what exactly are these better solutions and how do we know whether they would have worked? We cannot answer this with much certainty. Remember that we have only one history. We can speculate and debate but a real test of theories and proposals for alternative policies would have to wait until a new battle.

And meanwhile, we can examine the facts. Inflation [in Ukriane] is below 5% (lower than in Russia). The banking system is secure and stable. The payment system is fully operational. Interest rates are gradually climbing down. The hryvnia is floating towards a market-based equilibrium.  Ukraine’s economy is growing (faster than Russia’s). Despite extremely adverse odds, Ukraine’s economy is coping with a devasting shock better than many observers expected.

Does the National Bank of Ukraine deserve credit for this resilience? Yes, it does.

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