The war economy arrives in Europe

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The West is not exactly at war with Russia. However, he’s not exactly at war either. Western weapons helped Ukraine block the Russian invasion and even counterattack, while Western economic sanctions clearly created serious problems for Russian industry.

Russia retaliated with a de facto embargo on natural gas exports to Europe. This shows how Vladimir Putin actually thinks the war is going. After all, it will have huge long-term costs: no one will ever consider Russia a reliable trading partner again. But Putin appears ready to bear those costs in an attempt to bully the West into reducing its support for Ukraine – something he wouldn’t do if he were confident about the military situation.

In any case, the embargo has raised the economic stakes. Six months ago there was a lot of discussion about whether Europe could or should stop importing energy from Russia. Well, Russia did indeed make this decision on behalf of Europe.

And Europe seems ready to respond by doing what democracies always do when faced with wartime inflation: impose windfall taxes, control prices and (probably) ration.

Before we get to that, let’s note that for the moment, at least, we are talking about a specifically European problem. America is currently on something of an inflation holiday, thanks in large part to falling gasoline prices, but also reflecting other factors, like falling shipping costs.

Europe, however, has allowed itself to become highly dependent on gas flowing in from Russia – a flow that has now been largely cut off.

It is important to understand the nature of the problem with this cut. The physical scarcity of gas, while real, shouldn’t be crippling; Europe currently has higher than normal amounts of gas in storage, and between conservation measures and alternative energy sources, Europe should be able to get through the winter without freezing.

Rather, the key issue is financial and, ultimately, social. Gas prices in Europe have soared, and as buyers turn to alternatives, prices for other energy sources, including nuclear, renewables and coal, have also soared.

Textbook economics says this is how things are supposed to work. Europe faces a major energy deficit; higher prices incentivize everyone to make up that shortfall. Consumers will be encouraged to lower their thermostats, improve their insulation and wear sweaters. Producers will be incentivized to maximize production and increase capacity. Letting the markets do their job is the effective policy.

It is also grotesquely unfair. Energy producers whose costs have not increased will reap huge profits, while many families and some businesses will be ruined by gigantic energy bills. Lectures to losers on the importance of efficiency incentives will not appease them.

There is also a macroeconomic risk. Europe still has strong unions, and some of them will be able to demand wage increases to compensate for the soaring cost of living. This could result in a price-wage spiral that would be costly to untangle.

So letting energy prices rise is not really an option.

What if lump sum checks were distributed to compensate families for higher energy costs? On paper, this might seem like a good idea, as people would still have an incentive to limit their energy consumption. In practice, however, different families, even if they have similar incomes, can have very different energy bills – and people who live in poorly insulated homes cannot solve this problem on very short notice.

So Europe seems ready to do what, as I said, democracies always do with wartime inflation: try to protect the public against very large price increases, and also try to prevent extremely high profits in times of public distress.

On Wednesday, Ursula von der Leyen, the President of the European Commission, released an energy statement calling for “a mandatory electricity consumption reduction target” (i.e. rationing), a “revenue cap” of low-cost energy producers. (i.e. price controls) and a “solidarity contribution” for fossil fuel producers (i.e. excess profit taxes). It is important to note that von der Leyen is not a head of government and has very little direct power. But the measures it proposes probably give a pretty good idea of ​​where Europe is headed.

Will it work? The details will of course be crucial. An encouraging sign is that Europe is clearly not going to pull a Nixon and try to suppress inflation with controls while stimulating the economy. On the contrary, these kinds of wartime controls will come at a time when the European Central Bank is tightening its monetary policy sharply, at the considerable risk of triggering a recession.

We’ll see how it goes. But we are learning the realities of economic policy in real time. You can’t – in fact, you shouldn’t – always let the markets crash. It would be a bad thing if the emergency controls that Europe seems to be about to impose became permanent. But right now, protecting families and preserving a sense of fairness must take precedence over the efficiency of the textbook market.

The New York Times

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