Sanctions will deepen euro area deflation

Bottles of milk stand in a chilled cabinet inside a supermarket in Moscow, Russia.
Andrey Rudakov | Bloomberg | Getty Images
Bottles of milk stand in a chilled cabinet inside a supermarket in Moscow, Russia.

France's powerful farm lobby asked last Friday for an immediate removal from the market of all EU fruits and vegetables that can no longer be exported to Russia. A similar action was urged with regard to milk, milk products, meat and fish.

The fear is that excess supply would crush food prices and a heavily subsidized EU farm sector.

The European media are abuzz about sanction effects. Dutch, for example, reported today (Sunday, August 10) that last Friday one kilogram (2.2 pounds) of spinach in the city of Zaltbommel was down to €0.30 from €1.1 when the sanctions hit the market on Wednesday, August 6.

At this writing, an expert group is working at the EU Commission to assess the impact of this initial round of economic warfare with Russia. A broader group of national farm officials is expected to meet next Thursday, and Brussels is promising that "up to €400 million" could be paid out to compensate the sanctions-hit farmers.

Looking at all this, several things come to mind.

Read MoreECB 'won't move a muscle' despite deflation fears

First, this should have come as no news to the EU. Russia has been repeating for months that it would respond to Western sanctions. After the third wave of crippling measures directed at several sensitive sectors of Russian economy in mid-July, Moscow warned that it would target the EU farm business, and that further action will affect trade in automobile, aircraft and shipbuilding industries. Russia delivered on the first part of its counter-sanctions on August 6, 2014.

EU unprepared for trade war

In spite of all the warnings, the EU now seems totally surprised and indignant that Russia dared to respond. That is an unfortunate lack of EU preparedness to play this deadly serious sanctions game. As a result, a number of countries (Finland, Poland and some Baltic states) have already asked Brussels to compensate them for their trade losses.

Second, the compensation of "up to $400 million euros" promised by Brussels is wholly inadequate.

Russia is the second-largest market for EU farm exports. It takes 10 percent of EU farm products representing annual sales of €12 billion. France alone accounts for about €1 billion of that export trade with Russia.

No wonder the influential German and French media are now turning on their governments.

Witnessing the sinking of their equity market (down 11 percent since its peak in late June), the Germans are reminding themselves of how much their government ignored the teachings of their own war strategist (General Carl von Clausewitz) about the management of hostilities. And in an apparent dig at Chancellor Merkel, her Foreign Minister Steinmeier complained recently that "sanctions alone are not a policy." The raw nerve was apparently also touched by the news last Friday that the company Rheinmetall is now asking the government to use taxpayers' money to compensate it for a €100 million contract it was forced to cancel with Russia.

Read MoreRussia retaliates with sanctions: Winners and losers

The beleaguered French President Hollande – facing dismal approval ratings,stagnant economy and rising unemployment -- did not dare cancel the contract for the delivery of two warships entirely paid for by Russia. He also showed considerable urgency last Friday in endorsing the farm lobby's request for action at the EU level. In spite of that, the center-right opposition is virulently attacking Hollande for France's falling influence in world affairs – a coded message for an alleged loss of France's independent foreign policy, the most serious accusation one might level at a French leader.

French-German discord

To make things worse, the European trade war is coming at a very difficult time in French-German relations.

Fully supported by Italy, France never gave up insisting on its long-standing request for less stringent fiscal policies (imposed by Germany) to give some oxygen to struggling euro area economies. In a broad-ranging newspaper interview last Monday (August 4), Hollande also called on Germany to stimulate its domestic demand, and to recycle its huge external surplus of €200 billion – the largest in the world, representing about 7 percent of the German gross domestic product (GDP) – by investing in projects that could benefit its euro partners.

Two days later (on August 6), the government in Berlin peremptorily dismissed the French entreaty by saying that "very general statements coming from Paris provide no reason for any change of German economic policies." Such a brusquely imperious language is hardly the stuff of supposedly close friends and reconciled erstwhile sworn enemies.

On the same day, announcements came out that Italy's economy was back in recession, and that Germany's bellwether manufacturing orders fell 3.2 percent in June from the previous month. That came on the heels of a report that German business sentiment declined in July for the third consecutive month, and that German investor confidence was down for the seventh month running.

Can the European Central Bank (ECB) save the day?

I don't see what they can do. There has been some progress in euro area bank lending during June, but it is too early to say whether, and to what extent,the ECB's latest round of easing will help to keep the area's economy from slipping into recession. Bank lending to households and non-financial corporations in June was less negative than in the previous month, but mortgage loans – a good indicator of future consumer demand – were slightly weaker.

Read MoreEuro zone inflation falls again amid deflation fears

High unemployment and increasing political uncertainty created by Europe's escalating trade war don't bode well for euro area's loan demand to fund household consumption and business investments.

Under these circumstances, it is not clear what the ECB can do, in addition to what it has already done, to tackle problems in an environment of rising insecurity.

Investment thoughts

The euro area -- the core of the EU -- is facing grave difficulties of a deflationary economy. Problems of a structurally weak aggregate demand have been considerably increased by an unfolding trade war with Russia. In addition to that, the area's economic instabilities are compounded by Germany's refusal to reduce its excessive trade surpluses with stronger domestic spending.

Diplomatic solutions to the Ukrainian problem seem nowhere in sight, mainly because France and Germany are unable to agree on this and many other critically important issues.

Read MoreEU hits Russia with new military, financial sanctions

The euro area equity markets are showing that the greater the country's economic exposure to Russia the more damage is done to asset prices. That will continue. As an aside, however, please note that some battle-hardened investment veterans are telling us that bottom fishing in Russian equities is the best game they see.

The ECB will hold together the monetary union. Sadly, that is the only euro positive thing one can say at the moment.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.

Follow the author on Twitter @msiglobal9